Wealth Transfer in 2020

The SECURE Act of 2020 has changed the rules regarding wealth transfer and wealthier families need to examine those rules and most likely make some changes in how they plan to pass money to children and grandchildren. In this article, we’ll discuss “stretch IRA” provisions, Roth IRAs, Roth Conversions, and how the rules have changed.

The Old Days

The SECURE Act of 2020 changed a few rules and one important one was inherited IRAs. In the old days (2019), a person would often add children, grandchildren, or even great grandchildren as beneficiaries to his or her IRA. Would the beneficiary have to take RMDs? Yes, but the RMD for a 20 year old is very small and could last for 60 years or more. This is where the terminology “stretch IRA” came from.

For example, let’s take Jane, a hypothetical 80 year old who started, built, and eventually sold her own business. She grew her 401k over the years to $3mm and it has been rolled into an IRA Rollover from which she is taking her RMDs. She owns three homes free and clear, has an investment account totalling over $5mm, and has no spouse. Jane will leave her homes and investment accounts to her two children, and would like to split the IRA account evenly 3 ways to each of her 3 grandchildren who are 22, 24, and 26 years old respectively.

If Jane had passed in 2019, the 22 year old would inherit $1mm and her RMD would be $16,367 (1.64% of the account value). The 24 year old’s RMD would be $16,920 (1.7% of the account value) and the 26 year old’s would be $17,483 (1.75% of the account value).  Even at the age of 50, the 26 year old’s RMD would be only 3% of the IRA’s value. In other words, this money, with average market returns of 7% or so, would last a very, very long time and the withdrawals would add only negligible taxes to the inheritor’s tax bill.

The SECURE Act: 2020 and Beyond

Using our same example with Jane, let’s say she passes in 2020 rather than 2019. Her grandchildren each inherit the same amount of IRA assets of $1mm. The good news? There are no RMDs. The bad news? The inherited IRA accounts need to be completely empty within 10 years…..emptied in whatever fashion the beneficiary deems best as long as all assets are taken by the 10th year.

This accelerated withdrawal rule will significantly raise the tax bracket of most beneficiaries. Even if our hypothetical 22 year old beneficiary lets the account grow every year at 6% and then empties the accumulated ($1,791,000) amount in the 10th year, Federal taxes would likely be in excess of $700,000. What if our beneficiary is doing very well at work and really doesn’t want the money? It doesn’t matter. The entire amount must be withdrawn by the 10th year.

One Solution for the New Rules

Most estate planners now recommend that IRA owners take a hard look at Roth Conversions: Moving assets from an IRA into a Roth IRA. In our above example, perhaps Jane decides to take $100,000 this year from her Traditional IRA and move it to a Roth IRA. Jane would pay taxes on that money, but the money would go into a Roth IRA and the young beneficiaries would not face the same tax consequences upon withdrawal that they would with the Traditional IRA. Roth IRAs are subject to the same 10 year withdrawal policy that Traditional IRAs face, but the money is not taxable upon withdrawal. The withdrawals by the beneficiaries of those Roth IRAs would be tax free.

There are many variables that one needs to take into account when considering this: What is Jane’s tax bracket compared to the beneficiary’s tax bracket? Perhaps Jane’s granddaughter does well and is making over $400k a year and is in a higher tax bracket than Jane. In that case, perhaps it makes sense for Jane to take the tax hit rather than her granddaughter. Perhaps another one of the grandchildren struggles a bit and makes $50,000 a year. In that case, perhaps that grandchild’s inheritance should remain in a traditional IRA because the tax bracket for that child is relatively low.

One Last Recommendation

Talk to your investment managers about SECURE Act 2020. Perhaps it makes sense to split an IRA into 2 different accounts…..one Roth IRA and one Traditional IRA. Perhaps the beneficiary designations should be made with the beneficiary’s tax bracket in mind. With a little forethought, not only can one help ensure that money gets to beneficiaries one desires, but that the money gets there in the most tax efficient manner possible.

Keep your questions coming, we look forward to helping you make (and save) money.