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Why You Should Review Your Estate Plan This Year

The Secure Act and IRS have added some wrinkles.

Christine Benz: Hi, I'm Christine Benz from Morningstar. The Secure Act eliminated the stretch IRA, upending many long-held estate-planning assumptions. Joining me to discuss some things to consider in the wake of the stretch IRA's demise is tax and retirement planning expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine.

Benz: Ed, I'm hoping that we can talk about some things that have changed with respect to estate planning. I'd like to start by talking about the stretch IRA, which met its demise. Can you talk about what that was and also why and when it became not an allowable maneuver for people from the estate planning perspective?

Slott: Yeah. When Congress created the Secure Act--and here's just an observation I've had after studying tax law for 40 years: Whenever Congress names a law, you can almost always bet whatever name they give it, it will do exactly the opposite. So, when I saw "Secure Act," I was saying to myself, "Hold on to your wallets" and sure enough, they upended 30 years of, really, estate planning law for IRAs and 401(k)s and other retirement accounts by eliminating the stretch IRA, so-called stretch IRA. That was the ability, if you had an IRA, to pass it on after your death to children or grandchildren based on their life expectancy, allowing them to build and defer just taking minimum distributions. Let's say, you gave it to a 10-year-old or a 1-year-old, they could go out 70, 80 years. Congress felt that was too good of a break. They shut it down for anyone who inherited in 2020 or later. So, if you inherited in 2019 or earlier--let's say, you were a grandchild and you have 50 years to go, you get to complete those 50 years. You're grandfathered from your grandfather's inherited IRA. But if you inherited in 2020 or later, chances are, if you're a nonspouse beneficiary, like a child or a grandchild, you will be stuck with this new 10-year rule. Everything has to come out of that inherited IRA or 401(k) or Roth IRA by the end of the 10th year after death.

Benz: I wanted to dig into that a little bit. People hear about this 10-year rule, and they might think that they're taking 10% in each year. How does that work from a practical standpoint?

Slott: Well, IRS just made this a lot more complicated. There's two versions now with a 10-year rule. For people who inherited from somebody who died before their required beginning date, say age 72, and a different version of it if you inherited from somebody who had already begun RMDs. Let's say, your dad already began RMDs and died at, say, age 75 or so, there's a different 10-year rule. If you inherited from somebody who died before their required beginning date, before age 72, the 10-year rule--let's say, you're a child or a grandchild, it's a simple 10-year rule. You don't have to take any distribution, say, the first nine years, or it's flexible. You can take what you want. There are no interim RMDs. So, it's one big RMD at the end of the 10th year. But recently, in late February, IRS just changed those rules. If you inherited from somebody who was already over 72 and taking RMDs. In that case, for some strange reason, IRS says, once the person who died started taking their RMDs, you can't stop the train. So, for years 1 through 9, you're going to have to take required minimum distributions as if you qualified for the stretch IRA even though you don't, so based on your life expectancy. But then, by the end of the 10th year everything again has to come out. So, it's the same 10-year rule, but you have those required amounts for years 1 through 9. It's going to be very complicated for the new beneficiaries.

Benz: It definitely sounds like it is. I want to talk a little bit about the estate planning perspective. For people who want to try to if not replicate some of the advantages of the stretch IRA at least help their heirs defer taxes a little bit longer. What's on the table for them? What are some options that they should be considering?

Slott: Well, for people that have larger IRAs, they may be in trouble because many of those people named trusts as IRA beneficiaries. They named them because they wanted postdeath control. I've had a lot of clients over the years. They said, "Look, I have $3 million in an IRA. I want my kids to get it and my grandkids, but I don't want them blowing it. I worked too hard for this money. I don't want them squandering it." They're always worried about who they marry, lawsuits, bankruptcy, divorce, judgment, they can't handle money. So, they name a trust. But now, a lot of these trusts may not work as intended because they, too, could be subject to this 10-year rule, and if the funds stay protected in trust, it could be worse. Not only do all the funds have to come out in 10 years, but it could be trapped at very high trust tax rates.

Just to give you an idea how high trust tax rates are in 2022: You hit the top tax rates, 37%, after just about $13,000 of trust income if the funds stay in the trust for protection. An individual wouldn't hit that top rate till over $500,000 of income. So, you can get the trust protection, but at what cost? So, one of the solutions for that is to do a Roth conversion and leave a Roth IRA to the trust. Yes, you have to pay tax upfront to convert to a Roth. But if you leave the Roth to the trust, you still have the same 10-year rule, but you eliminate the taxation, especially the high trust taxation because you paid the tax upfront. There you can get the postdeath control, but still the funds have to come out by the end of the 10th year after death.

Another option might be to scrap the whole IRA plan anyway, and that's what a lot of people are thinking about. In fact, I wrote about it in my book even as soon as the Secure Act came out. I've been saying that for years. But now, between that and the new IRS rules, IRAs, as Congress intended, have become a bad asset for wealth transfer, for estate planning. You may be better off, if that is your goal--in other words, you don't need that money, it was always earmarked, say, for your children or grandchildren--you may be better off taking down some of that money at today's rock-bottom low rates and putting it into a permanent life insurance policy and leave that to a trust for the children. It's a much more flexible asset to use, especially for a trust. There are no RMDs, no RMD rules, no trust tax rules, and best of all, no tax. So, it's a much better vehicle to use if that's your estate planning objective.

You could also, if you're charitably inclined, use charitable remainder trusts if you want to give to charity, because IRAs are always the best assets to give to charity because they're loaded with taxes. So, you could use one of these CRTs, but you have to be careful there. Charitable remainder trusts means at death your funds would go to the CRT--no tax--and the CRT would pay out income based on a larger amount to your beneficiaries. But if your beneficiaries die early, all the funds go to the charity. So, I wouldn't do that unless it was backed up, say, coupled with a life insurance policy on that beneficiary. In case they die early, the family could be made whole or then some. So, there are some limitations and costs to that. But those are some of the options to simulate a workaround the more complicated IRA trusts that are out there, many of which won't work anymore.

Benz: Right. And you mentioned that perhaps the IRA isn't the ideal asset for people to inherit. And you noted that actually taxable assets maybe a better option in that instance because they do get this step-up after your death, whereas the IRA is maybe a better option for charitable giving?

Slott: Yeah, IRAs are definitely the better option for charitable giving because, again, the foundational rule of all good tax planning, always pay taxes at the lowest rates. And IRAs are loaded with taxes. If you're charitably inclined, give those assets to charity and let your beneficiaries inherit more of the, what we call, the taxable, as you said, the other non-IRA assets where they get a step-up in basis on the appreciation. They get relieved of all the capital gain, the appreciation, during the lifetime of the person they inherited from. IRAs never get a step-up in basis.

Benz: But also, those taxable assets are nice charitable giving assets as well, right, because the person gets to take a deduction during their lifetime and the assets would all ...

Slott: Yeah, except if you're older. Sorry to say, the older you are, the closer you are to the other door. So, if you just wait a little longer, they're going to get that benefit anyway through the relief of the capital gain on the appreciation through step-up in basis.

Benz: Ed, great helpful overview. Thank you so much for being here.

Slott: Thanks.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.