Many Americans have begun adjusting to changes brought on by the sweeping tax overhaul enacted in 2017.
Alterations introduced by the recent Secure Act could have a big impact as well. Advisors specializing in retirement income planning, particularly for the affluent, need to know that some of these changes could cause eventual tax headaches, particularly those related to the new, later age for required minimum distributions, and the elimination of the stretch IRA.
Increasing the RMD age to 72 may seem to reduce the tax burden, as withdrawals from IRA accounts could be deferred an extra year or two over the old rules. Yet for clients whose IRAs are over-funded, the change could increase the lifetime tax bill. Another year or two years of deferral will allow the balances in these accounts to increase, which causes the RMD at age 72 to be larger than it would have been at 70 ½. If the client is able to provide for their desired lifestyle with less than the full RMD, then any excess RMD will be taxed at the client’s highest marginal rate, which may be higher than if the client were to spread withdrawals over more time.
Since, in the absence of advice, most well-funded clients generally delay IRA withdrawals for as long as possible, the default will likely be a shorter distribution period as well as a larger account balance, resulting in more income being taxed at the client’s highest marginal rate, albeit for a shorter period of time. If the client’s beneficiary is in a lower tax bracket, those changes could work out to be a positive; still, a second change—the creation of a 10-year distribution period for IRAs—makes that much less likely.
Prior to the Secure act, IRA distributions from inherited accounts could be spread over the beneficiary’s lifetime, the practice commonly referred to as a stretch IRA. The tax benefits of a stretch could be substantial, as only a small portion of the IRA was required to be distributed each year, allowing additional compounding and the ability to minimize withdrawals during the beneficiaries’ highest earnings years. The 10-year provision has both positives and negatives: creating more flexibility within the first 10 years after the client’s death, but also restricting that flexibility to a mere decade. Planning opportunities will abound for people who need to coordinate the usage of their inherited IRAs with their own IRAs.
A younger beneficiary may not be able to retire within 10 years, which means that withdrawals should be spread out strategically, so as to take advantage of lower earning years, or could be coordinated with an increase in 401(k) contributions to offset the higher income and effectively reset the clock on those funds to the beneficiary’s RMD age.
Another complication is related to trusts established to control IRA distributions. In the past, advisors have used trusts to help clients control funds after their death, but the Secure Act has thrown a wrench into trust planning. Some trusts were written so that a client’s beneficiary can take only the required distribution. If such a trust is not modified, the beneficiary should prepare for a less-than-ideal tax situation: all of the IRA money will be forced out of the IRA in the final year, causing the effective tax rate on these funds to be a lot higher than if distributions had been spread out and filling lower brackets throughout the 10-year period.
For more information, please read:
How to Avoid the Secure Act’s Long-Term Tax Traps | ThinkAdvisor