Taxpayers with the largest IRAs (and their beneficiaries) will be in higher tax brackets in the future. Doing nothing now is a bad plan. Tax-deferred traditional IRAs will continue to grow, and so will the tax bill that eventually comes due. The SECURE Act is a giant wake-up call to do the long-term thinking that should have been done since the beginning.

Reversing Course
People with high incomes or ample assets—as well as those likely to be there in the future—should stop contributing to pre-tax 401(k)s and IRAs. The tax deductions offered by such accounts are merely loans from the government that will have to be paid back at the worst possible time: in retirement. Worse yet, the payback may come from the accounts’ beneficiaries who could inherit in their peak earning (and peak tax bracket) years.

That always has been the case with tax-deferred retirement accounts. What was the game changer? The SECURE Act’s 10-year rule.

An age-old CPA mantra notes that tax laws are written in pencil! Previously, such beneficiaries could stretch distributions over life expectancies, perhaps building up enormous amounts over multiple decades. Even after dealing with all the IRA rules and the ultimate tax bill, the net gain could be plentiful.

Now, under the original SECURE Act, and explained in the final regulations, most non-spouse beneficiaries of retirement accounts must take total distributions within 10 years. The 10-year rule shortens the window for complete depletion of all retirement funds. The shorter the window, the larger the required withdrawals and the higher the resulting tax bracket.

Preferred Path
The best way to approach this new landscape is to avoid a “minimum” mentality. Do not let RMDs drive your tax planning. With this outlook, the 10-year rule does not matter, so it can be ignored. RMDs do not matter, so ignore them.

Instead, think “maximum”: How much can be withdrawn now, and in the near future, at relatively modest tax rates? Tax planning should drive retirement account distributions. Even though the RMD age has been raised to 73, doing nothing until age 73 is a mistake. That may result in more wealth inside traditional IRAs, which must be distributed by account owners and beneficiaries. Those distributions probably will be highly taxed, especially for people with large IRAs.

To avoid that tax trap, it’s time for un-required distributions. Start trimming IRA and other retirement account balances now in order to use today’s historically low tax rates. Take full advantage of the current 12%, 22% and 24% brackets while they are available.

What’s more, recent inflation has raised the income levels for these rates. In 2024, the 24% tax rate is in place for taxable income (after deductions) of up to $191,950 for single filers and $383,900 for married couples filing jointly. After that, a 32% rate takes effect.

Action Plans
Savvy tax planning includes taking pre-tax distributions from retirement accounts this year, up to the taxable income amounts mentioned. Assuming the net cash flow is not needed for living expenses, what might be done with the excess funds?

• Roth IRA conversions: Although there are income limits to Roth IRA contributions, there are no limits for Roth IRA conversions. Roth IRA conversions generally are more effective if non-IRA funds are used to pay the tax. That will mean more money in the Roth account, where qualified distributions are tax-free after 5 years and age 59½.

Moreover, after-tax amounts in a Roth IRA can be withdrawn, untaxed, at any time. Consequently, taxpayers holding ample Roth IRAs have enormous flexibility in tax planning. For example, tax-free Roth IRA withdrawals might be used to hold down future income for purposes of avoiding steep Medicare premiums.

The tax-free treatment of Roth IRA distributions also applies to inherited Roth IRAs, so beneficiaries will not owe tax on distributions even if general tax rates climb in the future. However, beneficiaries of traditional IRAs cannot execute Roth conversions. For estate planning purposes, Roth IRA conversions at modest tax rates can make sense at any age, passing the opportunity for untaxed distributions to future generations.

• Life insurance: Taxpayers who are age 59½ or older may want to use the net proceeds from pre-tax retirement account withdrawals to purchase insurance on their own lives, payable to descendants. The tax benefits of life insurance are exceptional. For one, payouts to beneficiaries usually avoid tax, regardless of the recipient’s income.

In addition, permanent life policies (typically a version of whole life, universal life, or variable life) often include a cash value account. Any investment income within the cash value will avoid tax; the cash value can be tapped by the policy owner, tax-free, via prudent withdrawals and policy loans.

It’s true that premiums for permanent life insurance tend to be much higher than they are for term life coverage. That said, if workers and their spouses are not contributing to pre-tax IRAs and employer plans, as recommended here, their after-tax dollars might go into permanent life policies.

• Charitable donations: At the other end of the age spectrum, taxpayers age 70½ or older should plan on making their charitable contributions directly from their IRAs, via qualified charitable distributions (QCDs). These donations count as RMDs but not as taxable income, so they allow IRA owners to reduce tax-deferred balances without paying tax. Meanwhile, appreciated assets in taxable accounts can remain there, without being donated, and eventually pass to heirs with a tax-favored step-up in basis.

Young or old, people with philanthropic intent should cancel all bequests of non-retirement assets to charity; instead, favored causes can be named as IRA beneficiaries. Charitable recipients will owe no income tax and money can be removed from the decedent’s IRA with no tax for the beneficiary.

Yet another tactic to consider is to name a charitable remainder trust (CRT) as IRA beneficiary. Again, money flowing to charitable beneficiaries won’t be subject to income tax. What’s more, the value of CRT assets expected to pass to charity are excluded from estate tax, which might be a major attraction with the estate exemption scheduled to decline. (Life insurance may serve to make up for IRA funds lost to loved ones because of the CRT bequest.)

Trust Tactics
On the subject of trusts, naming a trust as beneficiary of a traditional IRA may not be a good idea. Under current law, the top 37% tax rate kicks in when 2024 trust taxable income exceeds only $15,200! RMDs alone on larger IRAs may easily exceed $15,200 and can be taxed at that rate if income is retained in the trust, which may be the case for a discretionary trust that is the IRA beneficiary.

That’s not to say that a trust cannot be a good fit as an IRA beneficiary. A well-crafted trust can provide control over a large inherited IRA if there are concerns about how a loved one will handle the inheritance. Such control can reduce the risks of overspending, overconfidence in con artists, costly divorces, etc.

Again, the solution here is to convert traditional IRA dollars to the Roth side via a conversion. A Roth IRA makes a better trust beneficiary because distributions from an inherited Roth IRA to the trust will be income tax-free, even if the funds are retained in the trust. Roth IRA funds left to a trust remove the trust tax problem for inherited IRA funds retained in the trust.

Taking these steps can result in larger legacies with less (or no) tax due. Think maximum, not minimum! Let long-term tax planning drive distribution planning to control tax rates today, tomorrow, and in the years to come.

Ed Slott, CPA, is founder of www.irahelp.com. He will conduct a webcast on Breaking Down New RMD Rules with Financial Advisor tomorrow at 1:00 p.m. To register, click here.

Upcoming 2-Day Program (Virtual) - September 19 – 20, 2024