Prevent tax bracket creep among IRA beneficiaries with these three considerations.
When the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed, the headlines read: So Long, Stretch. Savers had long bequeathed hefty IRA balances to much younger heirs, who would stretch the distributions over their (hopefully) longer life expectancies, stretching the tax liability as well. Now, most beneficiaries have just 10 years after the account owner passes to withdraw the entire balance of the inherited IRA. This could cause bracket creep for the heirs, meaning these larger, accelerated distributions from the inherited IRA could inadvertently push them into a higher tax bracket. This would particularly affect those who inherit large IRA balances or are in their prime earnings years.
The IRS carved out a few exceptions, though, which offer some planning potential. The 10-year deadline doesn’t apply to these eligible designated beneficiaries:
- Disabled or chronically ill beneficiaries (per IRS guidelines)
- Beneficiaries who are less than 10 years younger than the deceased account owner
- Minor offspring, though the 10-year clock starts once your child reaches the age of adulthood in the applicable state
With all the changes it brings, we don’t blame you if you’re a bit bewildered by the SECURE Act. It is complicated, but here are a few ways you, your financial advisor and tax professional can help position your financial, tax and estate plans for year-end and beyond.
Consider bestowing IRA assets to beneficiaries who might be in a lower tax bracket and reserve other assets, like appreciated stock, life insurance and/or brokerage accounts, for those in higher ones, who will likely benefit from stepped-up cost basis. If you prefer, you can also pass your retirement account to multiple beneficiaries to spread out the inherited balances and potentially avoid bracket creep.
Say you choose your spouse. You can also name your child as a co-beneficiary. That child gets a 10-year window to draw down his or her portion of your IRA balance. If your spouse also designates the child as a beneficiary, that child will have another 10-year window to draw down that balance after inheriting.
See to see-through trusts
If you’ve designated a trust as beneficiary to a qualified retirement account, make an appointment with your attorney sooner rather than later. Many families used see-through conduit trusts to allocate required distributions to their heirs. But the trust document in conjunction with the new SECURE Act legislation could require those trusts to wait until the 10th and final year to dole out the entire account balance. That lump sum comes with potentially larger tax consequences. An accumulation or discretionary trust, on the other hand, offers the trustee added discretion to distribute the funds in a more tax-efficient way. The rules here are a bit tricky, so be sure to consult an attorney for guidance.
Another option? A charitable remainder trust, which receives the inheritance tax-free, then provides an income stream to a designated heir over their lifetime or some other set period of time. Any remainder is reserved for the indicated charity.
Inherited Roth accounts are also subject to the 10-year rule, but the distributions are usually tax free. For those in a lower tax bracket than their intended beneficiaries, it could make sense to strategically convert a traditional IRA to a Roth to help your eventual heirs avoid tax consequences. However, that means you would pay income tax on the converted amount, and it’s best to have enough assets outside of the retirement account to do so. Mini conversions should provide more tax efficiency than a lump-sum conversion. Be mindful of your tax bracket threshold to avoid pushing yourself into a higher one. A conversion may make even more sense when the market is down.
The SECURE Act has wide-reaching impacts on retirement savings, tax planning and estate planning for many Americans. Be sure to consult your financial advisor and tax professional for guidance on what this new law means for you.
Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.
Economy & Policy February 28, 2024 Raymond James CIO Larry Adam notes that while there may be a period...
Retirement & Longevity “Backdoor” strategies let you enjoy the benefits of a Roth while getting...