Estate Planning Considerations for Retirement Assets & The SECURE Act

Connor SmithSeptember 18, 2020

Estate Planning

Death of the Stretch IRA:

  • With the passage of the SECURE Act at the end of 2019, also came the death of the ”Stretch” IRA technique for most non-spouse IRA beneficiaries.
  • Starting in 2020, when most non-spouse beneficiaries inherit a retirement account, they can no longer take distributions over their lifetime. Accounts that are affected include 401(k)s, IRAs, 403(b)s, 457 plans.
  • When most non-spouse beneficiaries (over 18) inherit a retirement account, they must liquidate the account within a 10-year period.
    • A non-spouse beneficiary under the age of 18 can take distributions based on their life expectancy until the age of 18. Once the beneficiary reaches the age of 18, the 10-yr rule goes into effect.
  • By the 10th anniversary of the original retirement account owner’s death, the inherited IRA account balance must be reduced to $0.
  • During the 10-yr period after the retirement account owner’s passing, the beneficiary who inherited the account is free to take distributions in any amount they choose.
  • This also means trust planning regarding the inheritance of retirement assets written into a will or included in a trust for a beneficiary should be revisited and possibly may have to be re-written, by an estate planning attorney. If you have a trust as a beneficiary of your IRA, we encourage you to contact our office to review these changes in more detail.  You can also expect that we will be revisiting this with you at your next review.

Federal Tax Implications (based on current laws):

  • Because pre-tax retirement account distributions are taxable in the year a distribution is taken at the individual’s personal income tax rate, this new law has significant tax implications for a beneficiary who inherits pre-tax retirement assets, when a distribution is made. This is due to the more rapid timeline the account must be liquidated in, plus distributions could elevate the beneficiary into a higher tax bracket.
  • Pre-tax retirement assets typically include Traditional IRAs, pre-tax 401(k)s, pre-tax 403(b)s and pre-tax 457 plans.
  • For an IRA account owner who passes on a pre-tax retirement account with a large balance, this not only means their beneficiary will have less flexibility on taking distributions, but the distributions taken will most likely be taxed at a higher rate than if the beneficiary were able to elect the previously allowed stretch IRA provision.
  • An example – A beneficiary inherits a pre-tax retirement account with a $2,000,000 balance:
    • If a married or single tax filing beneficiary waits 10-years before taking a distribution with the hopes that the IRA balance will grow tax-deferred for as long as possible, if the IRA balance is $2,000,000+ and they take a full distribution for the entire account balance in the 10th year, they will be taxed at the 37% rate on income over ~$510k for Single tax filers, and ~$612k for Joint tax filers.
    • If the beneficiary chooses to take a $200k distribution each year over 10-years, and the account balance does not grow, a single tax filer whose income is ~$204k or more will be taxed at the 35% marginal rate or higher for income above this level, while a married tax filer will be taxed at the 24% marginal rate or higher.
    • Note: This example is based on today’s income tax rates, and we have many reasons to believe income tax rates may be higher in the future, which may coincide with when many beneficiaries are actually taking these withdrawals.
  • Federal Estate and Gift Tax:
    • The current Federal Unified Estate and Gift Tax Exemption is $11,580,000 for a single individual. For a married individual who elects portability, the exemption is $23,160,000.
    • There is no inheritance tax at the Federal level.
    • Estate tax law and exemptions change frequently, often the laws in place depend on which party is in office.
    • Conservative politicians often prefer a higher estate tax exemption, while liberal politicians often prefer a lower estate tax exemption.

State-Specific Tax Implications (based on current laws):

Considerations for Pennsylvanians:

  • If a Pennsylvania resident passes away there is no state estate tax, but there is an inheritance tax.
  • If the decedent was a Pennsylvania resident, their child, grandchild, parent or other lineal heir will have their inheritance taxed at a rate of 4.5%.
  • If the heir is a sibling, the inheritance will be taxed at 12%.
  • All other heirs will have their inheritance taxed at 15%, except charitable organizations, exempt institutions and government entities exempt from tax.
  • There is no inheritance tax on gifts to a spouse or charity.
  • Distributions from an inherited IRA are exempt from Pennsylvania state income tax.

Strategies to mitigate taxes for beneficiaries and heirs (based on current laws):

Life Insurance:

  • Life insurance proceeds can be used by heirs or beneficiaries to pay for income, estate, or inheritance taxes levied.  Essentially the life insurance proceeds can be used to help mitigate all or a portion of the amount an heir or beneficiary may lose to taxes.
  • If the life insurance policy is owned by a properly structured Irrevocable Life Insurance Trust, or ILIT, and premiums for the life insurance are paid for by the ILIT, the proceeds from the life insurance could be excluded from the taxable estate.
  • Paying the premiums for a life insurance policy owned by an IILIT:
    • If an individual has excess cash flow, they can use it to gift to an ILIT to pay the premiums for a life insurance policy.
    • The money used to gift to the ILIT can come from wages, interest income, dividend income, capital gains, proceeds from RMDs that are not spent, etc…
    • If the gift to the ILIT is less than $15k-yr per beneficiary of the ILIT, it will not decrease an individual’s Federal Unified Estate and Gift Tax Exemption.
    • Gifts to the ILIT in excess of $15k-yr per beneficiary will reduce the Federal Unified Estate and Gift tax exemption, and the individual will have to file a gift tax return.
    • However, if the total gifts to the ILIT and total estate do not exceed the Federal Estate and Gift Tax Exemption, then there will be no estate or gift tax levied.
  • With the proper structure in place, you can successfully convert your IRAs that may be subject to federal estate tax, PA inheritance tax and federal income tax into a life insurance distribution that will be completely tax free!

Roth Conversions:

  • Converting pre-tax retirement account assets to a Roth IRA are another way that an individual can mitigate the tax impact of the beneficiary inheriting a pre-tax retirement account.  By converting pre-tax assets to Roth assets, the account owner can pay taxes now, and their beneficiaries can avoid paying taxes on the Roth assets when they make their withdrawals, after the account owner has passed away.
  • This does not avoid the 10-year liquidation rule for the account, but distributions from an inherited Roth IRA will not be subject to Federal or State income taxes.
  • The Roth assets can grow tax deferred up to 10-years. This can help maximize the value of these assets over the 10-year period before the beneficiary has to liquidate the account.

Considerations for charitably inclined individuals:

  • For an individual who is charitably inclined they may want to leave a portion of their pre-tax retirement account balance to a charity, instead of bequeathing non-retirement account assets.
  • A charity will not have to pay income taxes on the pre-tax IRA monies. Assuming the charity is a 501(c)3 organization and is tax exempt.
  • It is recommended that any charities be named as the direct beneficiaries on the pre-tax retirement account and not through the decedent’s will in order to maximize the income tax benefits.
  • There are also more complex estate planning techniques that charitably inclined individuals can use using charitable trusts. If an individual is interested in these techniques, this discussion would be best to have with an estate planning attorney.

After reading this, if you feel your estate plan should be revisited or you would like to learn more on any of the items discussed please contact your financial advisor or our office at 610-651-2777.


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