Three More Strategies That Beat the SECURE Act

The Stretch IRA is history, and you need to revise your estate plan to ensure your heirs receive maximum after-tax value from inherited retirement accounts.

You know the basics, because I’ve been covering them since the Setting Every Community Up for Retirement Enhancement (SECURE) Act started rolling through Congress in May 2019. You can read the basics in my articles in the July 2019, December 2019 and February 2020 issues.

Last month, I showed you two ways to use life insurance to set up the equivalent (or better) of a Stretch IRA for your loved ones. This month, I show you three additional strategies that will increase the after-tax wealth available to your heirs and make end-runs around the SECURE Act.For many families, the benefits from converting a traditional IRA to a Roth IRA were increased by the SECURE Act.

When you convert a traditional IRA to a Roth IRA, the amount you convert is included in your gross income that year and taxed. Many people don’t con-vert an IRA, because they don’t want to pay taxes before they must. They want to wait until money is distributed from the traditional IRA.Yet, paying taxes early in an IRA conversion can pay off in the long term. That’s because the Roth IRA is completely tax free. The income and gains in the Roth IRA compound tax free, and they remain tax free when eventually distributed.

Distributions of the principal also are tax free. Remember that distributions from a traditional IRA or 401(k) are taxed as ordinary income. When you invest through a traditional retirement account, you’re often converting tax-favored long-term capital gains and qualified dividends into ordinary income. Converting the IRA to a Roth IRA converts the future investment returns into tax-free income instead of higher-taxed ordinary income.

Of course, when your future income tax rates or the tax rates of the children who inherit will be higher than your tax rates today, paying taxes at today’s lower rates makes a lot of sense. A number of parents don’t convert IRAs because they expect their children will inherit the IRA and will be in the same or lower tax brackets than the parents are today.

But when you run the numbers, over the long term converting to a Roth IRA can make sense even when you expect the future tax rates on the distributions will be the same as or lower than they are today. Some other factors that are import-ant to consider before converting an IRA are the expected investment rate of return, how long the money will stay in the IRA to compound and whether the taxes are paid with money outside the IRA.

Remember that Roth IRAs are subject to the SECURE Act just as traditional IRAs are. That means the Roth IRA must be fully distributed to the beneficiaries within 10 years after it is inherited.

But the Roth IRA has an advantage the traditional IRA doesn’t. You can name a trust as a Roth IRA beneficiary and have the IRA distributed to the trust. Since Roth IRA distributions are tax free, the trust isn’t taxed at a high rate the way a trust is when it receives distributions from a traditional IRA.

In addition, the trust can accumulate the distributions and reinvest them. That keeps beneficiaries from spending them too quickly or investing them poorly. Also, in most states the trust protects the assets from creditors of the beneficiaries.

So, while a Roth IRA still must be distributed within 10 years after being inherited, there are benefits to converting a traditional IRA to a Roth IRA after the SECURE Act.See our February 2019 issue for details about the factors to consider before converting a traditional IRA to a Roth IRA.

Also, look at my book, “The New Rules of Retirement-Revised Edition.” I recommend you use one or more of the IRA conversion calculators available on the internet to help with your decision instead of trying to make it intuitively. There are a number of factors to consider, and it’s important to see what the numbers would be over the long term.Another strategy to replace the Stretch IRA is the charitable remainder trust (CRT).

There are many possible variations of the CRT, but a frequent arrangement is that you draft a charitable trust agreement providing that the trust will pay lifetime income to your children. After they pass away, the remaining trust assets are paid to one or more charities you named, or you can allow the CRT beneficiaries to name the charities. Then, you name the CRT as the beneficiary of your IRA.

This arrangement complies with the SECURE Act, because the IRA is distributed immediately to the CRT after your passing. Yet, you create results very similar to those of a Stretch IRA, despite the SECURE Act.

There are no income taxes when the IRA is distributed to the CRT, because the CRT is tax exempt.When distributions are made from the CRT to your beneficiaries, they are taxed as ordinary income to the extent that they are distributions of the current and accumulated ordinary income from the IRA. Once the IRA’s initial value is distributed, future distributions will be taxed based on their character when earned by the CRT: ordinary income, long-term capital gains, qualified dividends or other types of income.The trustee invests the CRT assets, so there’s no risk that unsophisticated heirs will invest poorly. The trust agreement determines the amount of the distributions. They are spread over the beneficiaries’ lifetimes, preventing the beneficiaries from spending them rapidly and wastefully. The CRT also protects the assets from creditors of the beneficiaries to the extent the assets haven’t been distributed.You choose to have the CRT pay the beneficiaries a fixed annual amount (an annuity trust) or a fixed percentage of the trust’s value at the beginning of the year (a unit trust).

The unitrust can provide inflation protection when the investment returns exceed the annual distributions, and the unitrust won’t run out of money since distributions are a percentage of the current trust assets. The annual distribution from a unitrust can decline if the value of the trust assets declines.

An annuity trust provides no inflation protection and can run out of money when the investment returns don’t exceed the annual distributions. IRS regulations say the trust must distribute at least 5% of its trust assets each year and not more than 50%. Using tables and interest rates issued by the IRS, the estimate of the amount eventually to be received by charity at the termination of the trust must be at least 10% of the trust’s initial value.

Because the interest rates used to make the calculation are so low right now, it’s impossible to create a CRT that will make lifetime payments for a beneficiary younger than 27. But the CRT can make payouts for a considerable number of years. The trust agreement can leave the details of the payout to the future by saying that when distributions begin the CRT will pay the highest permissible rate under IRS regulations at prevailing interest rates.

A potential disadvantage of the CRT is that distributions don’t vary from the formula in the trust agreement. If beneficiaries have a need for additional cash, they have to go to other sources. A CRT also can be complicated, and there can be costs to administering it. But many large charities will manage a CRT for little or no fee when they are ultimate beneficiaries of at least a portion of the CRT.

When your estate planner runs projections under different scenarios, you’re likely to find the CRT would pro-vide results similar to those of a Stretch IRA before the SECURE Act.A related strategy is the charitable gift annuity (CGA).

In a standard CGA, you transfer money or property to a charity in return for the charity promising to pay income to you or other beneficiaries you name for either a period of years or life. The payments will be less than those available from a commercial annuity. The difference is a gift to the charity.

You can designate that after you pass away, your IRA will arrange to transfer assets to a charity in exchange for a CGA payable to one or more beneficiaries you name. When payments are received by the beneficiaries, they are taxed as ordinary income until the initial value of the IRA is distributed. The tax treatment of distributions beyond that most likely will be taxed like those from a CRT.

The CGA is simpler than the CRT, and it can be used when the assets aren’t valuable enough to justify the cost of creating and administering a CRT.

CGAs also can be very flexible. The distributions can be deferred, so that income to the beneficiaries doesn’t begin until they reach a certain age. The longer the payments to the beneficiaries are deferred, the higher the payments will be. The amount of the distributions also can be graduated over the years instead of fixed. Both the CGA and CRT make only annual distributions to the beneficiaries.

If the beneficiaries need additional cash one year, they must seek it from other sources. That’s why it can be a good idea to use part of the IRA or other assets to purchase some life insurance payable to the beneficiaries.

Your IRA and 401(k) probably are among your most valuable assets. If you want these to benefit your children or grandchildren for an extended period of time, that will still happen, even after the SECURE Act. Review your options and choose the one (or more) that will maximize the after-tax wealth your heirs can enjoy for decades.