Protecting Your Heirs from Taxes and Creditors After the SECURE Act

Posted on Fri, Jan 29, 2021 ©2021 Drucker & Scaccetti

NetworkingBy: Elizabeth M. K. Witko, MAcc, MSF, and Robert N. Polans, CPA, MT, PFS


The tax impact of the Setting Every Community Up for Retirement Enhancement (SECURE) Act’s 10-year limited stretch can be a “keep you up at night” concern for individuals who have amassed substantial qualified retirement accounts. Often, these individuals have a substantial portion of their investment portfolios accumulating and growing in tax-deferred retirement accounts, and as a result of the SECURE Act, could be passing down a massive income tax liability to their heirs.



For decades, retirement planning strategies, structured with life expectancy tables and use of Conduit and Accumulation Trusts facilitated the stretching of inherited retirement account distributions over a protracted period and reduced taxation to beneficiaries.  Conduit or Accumulation Trusts are often used to protect inherited assets from beneficiary mismanagement, overspending, creditors or the possibility of a costly divorce. After the SECURE Act, many beneficiaries of retirement accounts are subject to the new 10-year rule which imposes numerous challenges to providing assets to beneficiaries at a low tax cost.


Impact of SECURE Act

Retirement accounts which are inherited post January 1, 2020, by all beneficiaries other than Eligible Designated Beneficiaries (spouses, disabled or chronically ill individuals, minor children of the decedent, or individuals not more than ten years younger than the decedent (EDBs)), are now subject to this 10-year limited stretch. All inherited retirement account assets (even ROTH IRAs and 401ks) must now be withdrawn by the end of the tenth year following the year within which the account holder dies, unless the beneficiary is an EDB. For beneficiaries bound by the 10-year rule, there is no longer a required minimum annual distribution requirement. This means that to get the maximum tax-deferred growth and avoid paying annual taxes, the beneficiary may be inclined to defer all or most distributions to the tenth year. The consequence, however, may be the payment of tax on all or most of the withdrawal at the top income tax rate in effect during the tenth year.


Conduit or Asset Accumulation Trusts can also be subject to the 10-year rule, so it is especially important to re-examine all retirement account beneficiary designations that include these types of trusts. It is important to review how the 10-year rule will impact the future taxes paid by these trusts and their beneficiaries and what options are available to account owners to mitigate the impact of this limited stretch.


For retirement accounts inherited before December 31, 2019, The SECURE Act also impacts successor beneficiaries who inherit retirement accounts after this date. Even if the original account owner has died before January 1, 2020, successor beneficiaries are no longer grandfathered and able to utilize the life expectancy of the original designated beneficiary and will generally be subject to the 10-year rule.


In these instances, for large IRAs, particularly those being inherited by only a few non-EDB beneficiaries, this can have a significant future income tax impact and reduce the after-tax benefit of these retirement accounts to the beneficiaries.



An oversimplified example illustrating the potential tax consequences to the beneficiary of a substantial account holder with one child as the beneficiary is as follows:

 - A child who inherits a $2 million IRA after January 1, 2020, can decide to spread out the withdrawals, say at $200,000 per year for ten years, or, alternatively, they could take a $2 million distribution in year ten.

 - Either way the difference in the tax impact is significant when compared to stretching distributions over a beneficiary's entire lifetime, as compared to post-death annual required minimum distributions (RMD) under the old rules. Even taking one tenth of an account balance out each year under these new rules and adding that to the beneficiary’s existing other taxable income will have significant tax consequences.

 - This example does not account for the fact that significant additional growth of the account over the ten years is likely to occur, nor the likelihood of future tax rate increases, which would both exacerbate the tax burden.

As income tax must be paid on these assets by either the account owner who is now required to take post-age-72 RMDs; or by recipient beneficiaries after death, optimizing wealth transferred to beneficiaries becomes a matter of frequent, strategic, long-term income tax planning.


Important Questions to Ask

Consultation with a trusted advisor is crucial to carefully consider and plan for the income levels, tax brackets, and individual concerns of the account owner and the beneficiaries designated to receive retirement assets and who will be affected by these taxes. Some considerations might include:

  • Is the account owner in a tax bracket that is expected to increase in the future?
  • Might there be a change in marginal tax rates or estate tax limits?
  • Is there enough liquidity to pay the estate taxes on these retirement assets without drawing down the retirement accounts and thereby creating an income tax event after death?
  • Will the beneficiaries be in top wage brackets?
  • What will be the income needs and spending patterns of the beneficiaries?
  • Are there any special needs trust concerns?
  • Are there existing trust documents that are now problematic?
  • Is a significant charitable donation a priority that could be incorporated into the estate plan?
  • Should any existing retirement plan assets be converted into a ROTH IRA during the taxpayer’s lifetime?

Planning Opportunities

One planning option gaining in popularity after the passing of the SECURE Act is the utilization of RMDs or Pre-RMD distributions by account owners to fund permanent life insurance on the account owner, or on the lives of the account owner and their spouse (second-to-die insurance). By drawing down taxable retirement plan balances during the account owner’s lifetime to pay life insurance premiums, an account owner may take advantage of lower tax brackets today and restore a greater amount of inheritance to the beneficiary(ies) of their accounts. When possible, it is helpful if premiums can be limited to being paid for only a fixed period as this increases the likelihood the insurance will remain fully funded and last until needed. This strategy, when structured properly, can provide completely tax-free life insurance benefits to beneficiaries, can be used to offset tax, and provide control over distributions. Another added benefit is there are no lifetime RMDs required on life insurance proceeds.


For clients with estate tax concerns, use of an Irrevocable Life Insurance Trust (ILIT) or having the beneficiaries themselves be the owner of the life insurance policy will prevent estate tax on the life insurance proceeds.   More often, an ILIT will be used so the trust can control the payout to the beneficiaries beyond the account owner’s lifetime.  


The conversion from a Traditional IRA to a ROTH IRA is also an important option to examine. The tax brackets of account owners today and the future brackets of beneficiaries need to be considered when weighing the benefits of a conversion. In this strategy, the income taxes on ROTH assets are essentially “pre-paid” for beneficiaries after conversion. After conversion, no RMDs would be due while the owner is alive and there would be tax-free growth to the account holder and their beneficiaries in the future. A popular approach is to process a partial conversion, say annually, to remain inside a current tax bracket. Other benefits may include the reduction of the estate by the income taxes paid on the conversion.


If tax rates increase due to recent changes in the country’s political leadership or complications from our national debt, then ROTH conversions or future distributions may be taxed at higher amounts. It may be better to make ROTH conversions now while the window is still open. If a ROTH Conversion is a good fit, there are things to know. Once the conversion occurs, the account can no longer be recharacterized back to a Traditional IRA by the tax return due date for the year of conversion, as in the past. Typically, it works best for the income taxes on the conversion to be paid with non-IRA assets, so cash flow or liquidity to convert IRA assets needs to be carefully planned. To offset the taxes due on a conversion the account owner could try to utilize 100% of the current year’s RMD towards the tax, couple the conversion with a larger charitable contribution (see note below), or utilize a Net Operating Loss (NOL) to help offset the income tax from the ROTH conversion.


NOTE - There is a unique opportunity in 2021 to offset 100% of the income from a ROTH IRA conversion with a cash contribution to a public charity, based on the suspension of the adjusted gross income limitations on charitable contributions created by the CARES Act and extended by the CAA 2021 into 2021.


Utilization of an Accumulation Trust can extend the time that assets stay within the protection of a trust and thereby extend the period that payments are available to beneficiaries. In such trusts, the trustee will have discretion over the timing of beneficiary distributions, which can then be stretched over periods longer than ten years. This technique, however, does not restore the financial benefits of the prior law’s stretch IRA because the IRA assets must still be distributed within ten years from the inherited retirement account to the accumulation trust. In addition, the Trust’s undistributed income will be taxed at higher trust income tax rates, which in 2020 was 37% on taxable income more than $12,950. The compression of tax brackets regarding trust taxable income becomes a steep price to pay for controlling the payout of these assets to beneficiaries.


Another powerful option to consider, particularly when there are charitable inclinations coupled with the desire to stretch out payments to beneficiaries, is to name a Charitable Remainder Unit Trust (CRUT) or Charitable Remainder Asset Trust (CRAT) as beneficiary. The CRUT/CRAT workaround utilizes the fact that charities and charitable trusts are exempt from the 10-year rule and the charitable trust can receive the IRA account tax free. The Charitable Remainder Trust would inherit the qualified account tax free and then distributions are made to the beneficiary over their lifetime or a maximum fixed term of 20 years. There would also be a charitable deduction available to the trust, or the estate based on the timing of the transfer. Complex calculations are required to determine whether the strategy is more advantageous overall as compared with the beneficiary(ies) inheriting the qualified account outright. Given the right variables, this strategy offers the opportunity to reduce taxation and stretch beneficiary payments while benefiting a charitable cause.


The past year has given us a lot to reflect on and the SECURE Act gives us even more to consider. The time to plan is now. Call on the experts at Drucker & Scaccetti to discuss how to mitigate the tax impact of your wealth transfer strategies.

Topics: beneficiary, Life Insurance, Roth IRA, RMDs, unprepared heirs, Traditional IRA, SECURE act

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