For many wealthy families, leaving a traditional individual retirement account, or better yet a Roth IRA, to the next generation remains a powerful planning tool.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act1 has dramatically changed the estate-planning options available to individuals with assets held in IRAs.2 IRA owners have long relied on the ability to stretch the tax-deferred life of an IRA beyond the IRA owner’s death, that is, the IRA owner could make the IRA payable to a designated beneficiary at death, typically an individual or a special type of see-through trust, and that designated beneficiary (or trust) could then take the required minimum distributions (RMDs) over his life expectancy (or the life expectancy of the oldest living trust beneficiary). The result was that an IRA could continue to remain invested in its tax-deferred status for years, or even decades, after the IRA owner’s death.
The SECURE Act has eliminated this stretch option for most IRAs. With the exception of five specific types of eligible designated beneficiaries,3 the life expectancy payout period has been replaced by a 10-year window, meaning that in most cases, all of the assets held in an inherited IRA must be withdrawn within 10 years of the IRA owner’s death.
In the wake of this seismic shift, IRA owners have been left scrambling to evaluate the next best option. Many IRA owners have the same, knee-jerk reaction: Maybe I should just leave my IRA to charity? At first glance, for an IRA owner in the highest applicable tax bracket who expects to be subject to estate tax, this option may seem very appealing. After all, for an IRA owner who lives in a high tax jurisdiction like New York City, the combination of federal and state income tax rates of 49.5%4 and federal and state estate tax rates of 56%5 means the entire IRA could be taxed away at death! If the government is going to get all of the IRA assets otherwise, why not leave the IRA to charity?
Keep or Donate?
It’s important to remember, however, that while the lifetime tax-deferred stretch may be dead, tax deferral over any period of time is still an extremely valuable and powerful tool. Our research at Capital Group Private Client Services shows that, even in a post–SECURE Act world, for an IRA owner who wants to pass significant assets to the next generation, keeping assets in a traditional IRA can still be a more attractive option than designating a charity as the IRA beneficiary. Furthermore, for an IRA owner who expects to be subject to the estate tax, a Roth conversion may be an even more attractive option. To illustrate these conclusions, we’ll use a case study (based on an actual client situation we recently encountered) to compare four different scenarios:
1. Keeping assets in a traditional IRA and designating the IRA owner’s children as beneficiaries;
2. Converting a traditional IRA to a Roth IRA and designating the IRA owner’s children as beneficiaries;
3. Designating a charity (for example, a donor-advised fund (DAF)) as the IRA beneficiary; and
4. Designating a charitable remainder trust (CRT) as the IRA beneficiary with children as lead beneficiaries to try to create a synthetic stretch IRA.
See “Key Assumptions,” this page, for a summary of the key assumptions applying to all four scenarios.
Case Study
Consider a 90-year-old widow (Mother) who’s used her entire lifetime exemption amount and has $8 million in assets that will be fully subject to federal and New York state estate tax, including a $1 million traditional IRA. The widow has a 60-year-old daughter (Daughter) who’s her sole heir. Mother and Daughter are both New York City residents subject to the top federal, state and local marginal income tax rates. Mother is ill and isn’t expected to live much longer.6 In all cases, we assume that Daughter doesn’t need to spend from this pool of assets, and they’ll continue to grow within her estate.
Scenario 1—Mother names Daughter as the beneficiary of the traditional IRA. In this scenario, all $8 million will be subject to a 56% combined federal and state estate tax. Assuming that estate taxes will be paid from non-IRA assets, after the $4.5 million in estate tax is paid, Daughter will inherit $2.5 million in taxable assets and a $1 million traditional IRA, for a total of $3.5 million in net inherited assets. (See “Summary of Inherited Assets,” p. 41, for a summary of these calculations).
One underappreciated change made by the SECURE Act is that while the assets need to be withdrawn from an inherited IRA within 10 years of the IRA owner’s death, there are no RMDs during that 10-year period. In this scenario, this means the $1 million can remain invested and grow tax-free over the next 10 years. Furthermore, in Year 10, when the daughter must withdraw the entire IRA, she’ll receive an income tax credit for the estate taxes that were paid on the income tax liability housed within the IRA (the income in respect of a decedent deduction).7 We estimate that 10 years hence, the taxable assets will have grown to $4 million. The $1 million IRA will have been allowed to appreciate to approximately $1.8 million and would net $1.1 million after paying income taxes on the withdrawal and adjusting for any deduction allowed for income in respect of a decedent.8 In total, we estimate that Daughter will have $5.1 million of assets. (Our estimates are included at the end of this article.)
What if Mother doesn’t want Daughter to inherit the IRA assets outright? As was the case pre–SECURE Act, there are still two types of trusts that can be designated as beneficiaries of an IRA: conduit trusts and accumulation trusts (sometimes collectively called “see-through” trusts). With a conduit trust, all distributions made from the IRA flow through the trust (after applicable deductions) to the individual life beneficiary, such that the trust acts as a conduit for the IRA distributions (hence the name).9 Post–SECURE Act, a conduit trust works the same way, such that a conduit trust will be entitled to the same 10-year payout period.10
Similarly, an accumulation trust will still function the same way it did pre–SECURE Act. With an accumulation trust, the trustee can accumulate IRA distributions inside the trust for later distribution to the trust beneficiaries in accordance with the trust terms, and, if structured properly, the accumulation trust will also still qualify for the same 10-year payout period.11
Scenario 2—Mother converts her traditional IRA to a Roth IRA and designates Daughter as beneficiary. When a traditional IRA is converted to a Roth IRA, income taxes are assessed on the market value of the assets in the IRA on the date of conversion, at the IRA owner’s current federal and state income tax rates in the year of conversion. However, once such income taxes are paid, under current law, any future withdrawals from the IRA aren’t subject to further income tax.
In this scenario, if Mother’s $1 million traditional IRA is converted to a Roth IRA before her death, Mother’s potential taxable estate will be reduced by the amount of income taxes she paid in connection with the Roth conversion. If such income taxes can be paid with assets outside the IRA (that is, from Mother’s taxable assets), allowing the newly converted Roth IRA’s value to remain at $1 million, Daughter will inherit $2.3 million in a taxable account and a $1 million Roth IRA. We estimate that 10 years hence, the taxable assets will have grown to $3.6 million, and the $1 million Roth IRA will have appreciated to approximately $1.8 million. In total, we estimate that Daughter will have $5.4 million of assets, resulting in $300,000 more money passing to her versus the amount in Scenario 1 (leaving the assets in a traditional IRA and designating Daughter as the beneficiary).
This may be a surprising result for some readers; however, the power of tax deferral is often underestimated. Having $1 million of after-tax money in a Roth IRA is more valuable than having $1 million in a traditional IRA, as the wealth in the Roth IRA is able to benefit from the 10 years of tax-deferred growth with no future tax liability. The embedded income tax in the traditional IRA and the estate tax due on Mother’s total assets at her death are sunk costs. The most efficient ways to pay those taxes are to: (1) pay the income tax on the traditional IRA prior to death by converting the traditional IRA to a Roth before death, avoiding an upfront payment of estate taxes on that income tax liability amount; and (2) pay the estate tax due from taxable, non-retirement assets. In fact, for families that are in this situation, the earlier Mother does the Roth conversion the better, as following conversion she’ll have eliminated RMDs for the remainder of her life.
This conclusion is specific to our assumptions that both Mother and Daughter are in the top federal income tax brackets and subject to estate tax on all assets and that Daughter can afford to leave her inherited assets untouched and invested for the full 10-year period. To the extent that Daughter is in a significantly lower income tax bracket and/or Mother or Daughter aren’t subject to estate tax, foregoing a Roth conversion and retaining the traditional IRA may be optimal. (See “A Compelling Strategy,” this page.)
Scenario 3—Mother designates a charity as the IRA beneficiary. Designating a charity as the sole beneficiary of Mother’s $1 million traditional IRA will result in a federal and state estate tax charitable deduction for Mother’s estate, and no federal, state or local income tax will be assessed on the IRA assets. After payment of federal and state estate taxes, we estimate that Daughter will inherit $3.1 million, all in taxable assets. Using our assumptions, Daughter’s $3.1 million in inherited taxable assets would grow to approximately $4.9 million over a 10-year period, approximately $500,000 less than what Daughter is projected to inherit in Scenario 2.
It’s important to note that an IRA owner’s charitable inclinations should be considered carefully in this scenario (as well as in Scenario 4, below). A charitable gift made to a DAF as the sole designated beneficiary of a $1 million traditional IRA at the IRA owner’s death would be projected to grow to approximately $1.8 million (See “Charitable Impact of Individual Retirement Account, p. 43) over the ensuing 10 years. This strategy should provide significant additional value to charitable organizations important to the family, almost doubling the size of the family’s charitable gifts, if the family is willing to wait 10 years to make those charitable gifts. This is a high leverage charitable strategy!
Scenario 4—Mother designates a charitable remainder trust (CRT) as IRA beneficiary with Daughter as lead beneficiary. Since the passage of the SECURE Act, many commentators have suggested that a “synthetic” stretch IRA can be achieved by naming a CRT as an IRA beneficiary. The basic idea is as follows: The IRA owner creates a CRT and designates the CRT as the beneficiary of his IRA. The CRT has a non-charitable lead beneficiary or beneficiaries (that is, individual descendant(s) of the IRA owner) who receive an annual income stream from the CRT12 during life (or for a set time period not to exceed 20 years), and the remainder left in the CRT on the death of the last living lead beneficiary/expiration of the time period passes to charity.
The IRA owner’s estate receives an estate tax deduction equal to the present value of the remainder interest passing to charity. The lead beneficiary(ies) pay income taxes on receipt of distributions from the CRT each year, as would be the case if distributions were received from an inherited traditional IRA. The difference is, with the CRT, the time period for making distributions to the lead beneficiaries isn’t limited to 10 years, but can instead be tied to the lead beneficiaries’ lifetime. Thus, goes the thinking, the IRA owner can simulate the stretch that was available on inherited IRAs pre–SECURE Act and defer the distributions made from the IRA for a longer period of time.
In this scenario, Mother creates a charitable remainder unitrust (CRUT) and designates the CRUT as the beneficiary of her $1 million traditional IRA. The CRUT has a required 5% annual unitrust lead payout to Daughter. Mother’s estate gets a $380,000 charitable deduction13 based on the present value of the CRUT remainder that will eventually pass to charity at Daughter’s death. Daughter inherits $2.7 million of taxable assets and is the income beneficiary of a CRUT funded with $1 million.
The CRT benefits Daughter more the longer she survives. As “Charitable Remainder Trust (CRT) Result,” this page, shows, over the very long term, the CRUT creates a bit more wealth for the next generation than does leaving assets in a traditional IRA (the orange CRT line starts below the red traditional IRA line, but passes it after 30 years) while also providing a benefit to charity. However, the CRT strategy still trails the Roth IRA conversion (gray line). For a 60-year-old beneficiary like Daughter, the 30-year break-even point is likely too long to make sense in the absence of a charitable objective.
Even for a younger beneficiary who has a life expectancy of 40 years or more, designating a CRT as an IRA beneficiary may still be suboptimal given mortality and liquidity risks. If the lead beneficiary passes away earlier than expected, any remaining assets in the CRT pass to charity immediately on death, and the benefit of the synthetic stretch is lost. Furthermore, assets in an inherited IRA can always be accessed early by the IRA beneficiary if needed, whereas assets held in a CRT can’t.
The CRT does have an estimated charitable interest of $500,000 in Year 10, as seen in “Charitable Impact of Individual Retirement Account,” this page, which may tilt the scales for a family looking for a balance between charitable and family wealth transfer objectives. The combined value to family and charity in Scenario 4 would exceed that of the value to the family only in the Roth IRA conversion in Scenario 2.
Tax Deferral Opportunities
By limiting the ability to stretch an IRA’s tax-deferred status to 10 years in most situations, the SECURE Act has reduced the benefit of accumulating significant assets in IRAs. However, IRAs still remain more valuable than many other assets due to still-remaining opportunities to defer taxes on IRA assets. As the case study above shows, individuals should continue to evaluate and avail themselves of the various vehicles that allow them to harness the power of tax deferral.
— Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.
Endnotes
1. Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, Pub. L. 116-94 (2019), www.govtrack.us/congress/bills/116/hr1865/text or Internal Revenue Code Section 401(a)(9)(H).
2. While the SECURE Act’s provisions apply to other types of employer-sponsored plans, the discussion in this article focuses on individual retirement accounts.
3. IRC Section 401(a)(9)(E)(ii).
4. Current top marginal income tax rates are 37% federal, 8.82% New York State and 3.648% New York City. For information on current federal rates, see Revenue Procedure 2019-44, www.irs.gov/pub/irs-drop/rp-19-44.pdf. For information on current New York State rates, see www.tax.ny.gov/pit/file/tax_tables.htm. The deduction that can be taken on one’s federal income tax return for state and local taxes paid is now limited to $10,000 (see the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97 (2017)).
5. The current top federal estate tax rate in 2020 is 40%, and the New York State estate tax rate is 16%. For information on federal estate tax rates, see Internal Revenue Code Section 2001(c), as amended by Section 302(a)(2) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853), Pub. L. No. 111-312, 124 Stat. 3296, 3301 (Dec. 17, 2010), as amended by Section 101(c)(1) of the American Taxpayer Relief Act of 2012; see“Instructions for Form 706 (revised August 2019),” at p. 5, www.irs.gov/pub/irs-pdf/i706.pdf. For information on New York State estate tax rates, see www.tax.ny.gov/pit/estate/etidx.htm; www.tax.ny.gov/pdf/current_forms/et/et706i.pdf and www.tax.ny.gov/pdf/current_forms/et/et706.pdf.
6. This case study is based on a true story. When we brought up options such as making lifetime taxable gifts or rolling grantor retained annuity trusts, which would be dependent on 2-to-3 years of survival, the daughter replied, “good luck with that!”
7. Generally, income tax must be paid on income received from an inherited IRA; however, a beneficiary can get the income in respect of a decedent (IRD) deduction on inherited IRA assets by showing that the estate of the deceased IRA owner already paid federal estate taxes on the inherited IRA assets. This rule exists to avoid double taxation. See IRC Section 691(c) for detailed information on how the IRD deduction works.
8. Ibid.
9. For a detailed discussion of how properly to structure a conduit trust as an IRA beneficiary, see Natalie B. Choate, Life and Death Planning for Retirement Benefits, 8th edition (2019), and in particular, at pps. 68, 71 and 393-485.
10. If the individual conduit beneficiary is one of the five types of “eligible designated beneficiaries,” the trust would be entitled to a life expectancy payout. See Section 401(a)(9)(E)(ii).
11. Supra note 9.
12. Supra note 9, particularly at pps. 526–531.
13. Assumes IRC Section 7520 rate of 2%.