In 2019, the U.S. Congress significantly overhauled the laws affecting retirement planning when it passed the Setting Every Community Up for Retirement Enhancement Act (better known as the “SECURE Act”). The SECURE Act’s primary objectives are to expand access to tax-advantaged retirement accounts like IRAs and 401ks and to allow more retirees’ savings to last throughout their entire retirement. What you may not be aware of, is that the Secure Act and your Florida estate plan go hand in hand concerning the rights and options for your heirs and beneficiaries.
Implementation of the SECURE Act only started in 2020, so it’s too early to say whether the law will achieve its goals. But we can say this: the SECURE Act will have a considerable impact on estate planning in Florida—especially planning for inheritance of retirement accounts in Florida (and elsewhere). If you’re developing a plan for an estate that includes an IRA or 401k, you’ll need to account for the revised rules. And, if you already have a plan in place, you may need to make some adjustments.
So, let’s take a look at the new law, its Florida estate-planning ramifications, and potential strategies for adapting to the changes.
What Does the Secure Act Do?
The SECURE Act has some pretty attractive features if you’re using an IRA or 401k in Florida to save for retirement. For one, the law does away with the former maximum contribution age of 70.5. Now, you can contribute to a retirement account at any age. And the new rules make it easier for part-time employees to participate in 401k plans and for small businesses to offer the plans. Congress wants as many Americans as possible saving for retirement, and the SECURE Act is undeniably calculated to increase participation.
For people retiring soon, the SECURE Act’s most significant changes are probably the new standards for how retirement account funds are withdrawn. Previously, IRA and 401k owners were compelled to start taking “required minimum distributions” (RMD), beginning at age 70.5. The SECURE Act bumps the mandatory RMD starting age back to 72. It might not sound like much at first glance, but that extra year and a half could have a big impact on how long your retirement savings lasts and on how much is left over on the back end.
The change is an acknowledgement that life expectancies have increased in recent decades and that more people are working later into their lives. By letting account holders wait a little longer to start tapping retirement account assets, the SECURE Act facilitates additional tax-deferred growth. More growth will hopefully allow retirement savings to hold up for more people. And, for retirees who want to pass along IRA or 401k wealth to their heirs, delayed RMDs could make it easier to maintain higher balances longer into retirement.
The Secure Act Limits on “Stretch” IRAs
So far, the SECURE Act sounds like it’s all up-side for taxpayers. Higher retirement account balances that last longer into retirement—what’s not to like? However the story is different when it comes to the Secure Act and you Florida estate plan.
As it turns out, Congress recognized that the longer tax-deferred growth and later withdrawals enabled by the SECURE Act would likely reduce federal tax revenue. And, so the law also includes a major provision intended to recapture some of that lost revenue, leading Forbes writer James Lange to describe the SECURE Act as the “Extreme Death-Tax for IRA and Retirement Plan Owners Act.”
Under new tax rules, a beneficiary of a retirement account who inherits an IRA or 401k upon the original owner’s death can no longer use a Stretch IRA to gradually distribute the account balance over the heir’s lifetime. It sounds simple, but the impact is potentially monumental.
What are Stretch IRAs?
Prior to the SECURE Act, Stretch IRAs were widely considered the most tax-efficient option for managing distributions from an inherited 401k or IRA. If you inherited a retirement account, a Stretch IRA let you “stretch” withdrawals of account funds over the rest of your life expectancy. For many beneficiaries, this translated into a reliable source of steady income for decades, and tax-deferred growth throughout the entire span.
A related approach prior to the Secure Act and related to your Florida Estate Plan, was to form a conduit trust in Florida and name it as the IRA’s beneficiary. Then, IRA funds would be distributed to the ultimate heir through the trust. Under the old rules, distributions could still be stretched out over the heir’s lifetime (if properly structured), but the trust let the original account owner exercise more long-term control over the wealth.
Under the SECURE Act, the entire balance of an inherited IRA or 401k now must be withdrawn within ten years of the original owner’s death.
The big tax advantage of a Stretch IRA was that it allowed the beneficiary to extend income tax liability attached to the inherited funds over his or her entire life expectancy. Remember, IRA and 401k contributions are pre-tax, so the wealth in the account is taxable income when distributed—even if distributions are going to the beneficiary and not the original account owner.
Because a Stretch IRA spaces out withdrawals over the longest possible time period, each individual distribution can be smaller. The result is reduced short-term tax bills and a potentially lower effective rate taxed to the entire inherited amount. And, perhaps more importantly, Stretch IRAs let the inherited wealth continue growing tax-deferred for a much longer time. Money that would otherwise be paid to the IRS instead continues compounding in the account.
The SECURE ACT Ten-Year Rule and Your Florida Estate Plan
Sadly (at least for those of us who are fans of tax-efficient financial planning), under the SECURE Act, the multi-generational deferred growth enabled by Stretch IRAs and some conduit trusts has gone the way of the dodo. Beginning in 2020, heirs are required to withdraw all funds from an inherited retirement account within ten years of the original owner’s death. You can still withdraw the entire balance immediately if you want to, and pay the big tax bill all at once. But the longest you can space out distributions (and therefore tax liability) is ten years.
The new ten-year rule comes with a few exceptions. First and foremost, inheriting spouses in Florida can still elect to stretch withdrawal of a spouse’s IRA funds over the remainder of the inheriting spouse’s life. Or, if the heir is a minor child in Florida, the clock does not start ticking on the ten-year period until the heir reaches the age of majority. And the ten-year distribution rule also does not apply to an heir who is disabled, chronically ill, or less than ten years younger than the original account owner.
Overall, the SECURE Act has some pretty valuable features likely to lead to real tax savings for retirees. But, the succeeding generation—the heirs who inherit retirement accounts—will likely see bigger tax bills and considerably less long-term growth potential for the inherited wealth.
Potential Stretch IRA Alternatives
Stretch IRAs allowed retirement-account beneficiaries to minimize total tax liability for the inherited funds while also maximizing deferred growth. Under optimum conditions, the result was exponentially increased wealth in the hands of the heir. Since the SECURE Act became law, estate-planning attorneys have been hard at work developing alternative strategies to approximate similar results.
An effective but somewhat limited approach is to convert a traditional IRA into a Roth IRA while the original owner is still alive. Roth distributions are not taxable income, so, even though the inherited account will still need to be emptied within ten years, the funds won’t be eroded by taxes during the ten-year period. In theory, each tax-free distribution is immediately reinvested in another tax-friendly investment to allow the wealth to continue growing.
The big disadvantage of converting to a Roth is that, when you make the conversion, you have to pay the income tax due for the account funds (ideally after you’re retired and your marginal tax rate is lower). And the money used to pay the taxes is no longer growing tax-deferred in the account.
A more complex, but potentially more rewarding, approach is to replace a future Stretch IRA in Florida with permanent life insurance. Because RMDs and whole life premiums are both based in part on life expectancy, it’s often possible to purchase a policy with a death benefit similar to the IRA’s starting value and premiums that can be fully paid-for with IRA distributions.
Upon retiring, the account owner begins taking RMDs and putting the IRA funds toward whole life insurance premiums. Taxes are owed for each distribution when made, and the corresponding premium payments decrease the IRA’s balance and increase the insurance policy’s cash value. If the retiree lives longer than anticipated, the policy’s cash value can be tapped to help fund later years of retirement.
When the policy’s death benefit is ultimately triggered, the payout goes to the beneficiary tax-free (life insurance proceeds are not taxable income). Or, policy proceeds can be paid into a Florida dynasty trust set up to spread out distributions over the beneficiary’s lifetime like with a Stretch IRA (or for whatever other period you prefer). A trust can have the added benefits of protecting the wealth from squandering and shielding it from claims of a beneficiary’s creditors.
Any funds remaining in the IRA can be inherited as normal and must still be distributed within ten years. However, because the balance has been reduced to pay policy premiums, the tax hit should be mitigated. Because life insurance proceeds are tax-free, they can be invested in full into another tax-deferred investment and continue growing with no tax liability until distribution.
While the SECURE Act undoubtedly makes it more difficult to maximize long-term, tax-deferred growth in an inherited IRA, a thoughtful estate plan can at least partially compensate for the changes. An experienced Florida estate-planning attorney can help you develop a tax-efficient strategy that accounts for the new rules and provides the greatest benefit to your heirs.
Steve Gibbs, Esq.