According to Steffen, unique situations include:
- When the beneficiary is older than the decedent—this beneficiary is in the EDB category because they’re less than 10 years younger.
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If the decedent owned a Roth IRA, which has no required beginning date:
- Left to spouse—roll over to a survivor’s Roth, with no RMDs during lifetime.
- Left to older EDB—life expectancy RMDs or opt into 10-year rule.
- Left to any other EDB—likely choose life expectancy RMDs.
- Left to non-EDB—10-year rule but no RMDs.
Helping Recipients Manage The Tax Burden
There are some serious considerations when tax planning for recipients, he said.
“Instead of taking smaller RMDs for years one to nine and then a big amount at the end as the account is emptied, it may be more advantageous for clients to take more level payments through years one to nine and avoid the big pop at the end,” he said. “That’s just the distributions—the real impact is the tax cost.”
Steffen used the following scenario as an example: an owner dies with $1 million IRA, left to a 55-year-old child, where the pre-tax return is 7% and the after-tax return is 5.5%, and the beneficiary is in the 40% tax bracket.
“Under the old tax rules, the beneficiary could take only those RMDs annually, pay the tax and then let the balance sit in a taxable account and not touch it so that it grows each year. The majority of the bequest would continue tax-deferred,” he said. “Under the new rules, the beneficiary has to liquidate that account within 10 years, and everything is now taxable. Over a 30-year period you can see the lost value to that beneficiary is approaching $600,000. Why is that? They’ve got a lot few years of money growing tax-deferred under a traditional IRA, and they’re taking out larger pieces of it and the tax hit’s much bigger. So that’s why there’s all this lost value.”
Another wrinkle, he continued, is that if the beneficiary is in a lower tax bracket without these distributions, the distributions themselves might push the beneficiary into a higher tax bracket, and the lost value is even greater. Using the same example as before but with a beneficiary otherwise in a 30% tax bracket, the distributions would push that beneficiary into a 38% tax bracket.
“And the lost value is now $1.115 million over 30 years, simply because they don’t get the tax-deferred growth anymore and they’re paying a lot more in taxes over a period of time,” Steffen said. “You’re going to have clients who are going to look at that and say that’s not their intention, and what can be done about it? 'How do we make sure my kids don’t lose out on that million dollars in value?'”
Steffen identified seven planning strategies around the 10-year rule, where the impact is felt by the beneficiary, not the owner, but only the owner can change the outcome. Each option requires deeper examination within a client’s individual situation:
- Tax-efficient beneficiary designations—leave assets based on tax status of beneficiaries, not proportionately. For example, leave Roth IRAs and life insurance to high-tax beneficiaries and leave retirement accounts to low-tax beneficiaries. This strategy requires periodic updates as account values, tax-brackets or tax laws change.
- Spend down the IRA during lifetime—withdraw from the IRA for spending and reinvesting, leaving other assets to the heirs, especially if the owner is in a lower tax bracket than the heirs. But avoid withdrawing from Roth accounts.
- Convert a traditional IRA to a Roth IRA—effectively paying the tax on behalf of the beneficiary.
- Make qualified charitable distributions—use IRA dollars during lifetime, but must wait until owner turns age 70½. Gifts can’t be made to some entities, and there’s a maximum of $100,000 per year.
- Leave the IRA to a charitable remainder trust—this avoids the 10-year rule. Either the IRA can be liquidated and transferred to the trust at no tax cost, or income can be paid to another beneficiary for life or a fixed period and then the balance goes to charity.
- Purchase life insurance—the IRA owner purchases life insurance to replace the amount lost to taxes for the beneficiary. Here the owner can use RMDs to pay the annual premium cost and use an ILIT to avoid estate inclusion.
- The beneficiary can make tax-strategic IRA withdrawals—during the first nine years can withdraw as much or as little as they want, so beneficiary can effectively spread out payments over 11 tax years.
“The only one who can really do something about this is the owner themselves, because once the owner dies and passes the IRA to the beneficiary, the beneficiary is locked in,” he concluded.