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When One IRA Window Closed, Another Opened

jar of currency labeled 'Retirement.'
photo by American Advisors Group (aag.com), via Flickr

Many Americans use tax season as an opportunity to give their financial lives an annual tune-up. This year, the SECURE Act gave everyone an extra impetus to take a close look under the hood.

As I have written before, the Setting Every Community Up for Retirement Enhancement Act included provisions that made a variety of changes to retirement planning, from potentially expanding access to annuities to modifying the “stretch” rules for individual retirement accounts. As financial planners, my colleagues and I have begun reevaluating our clients’ plans to see whether they need to make changes because of the SECURE Act.

One area that we have discussed at length is beneficiaries. In certain circumstances, the new law makes it useful to add more beneficiaries to qualified retirement plans, such as traditional IRAs or 401(k)s. But the details can become complex.

As I mentioned in my earlier post about stretch IRA provisions, the SECURE Act changed the rules about how beneficiaries can space out distributions from an inherited IRA. Under the new law, most nonspouse beneficiaries must distribute the entire inherited IRA within 10 years following the original owner’s death. This creates an opportunity. Couples who want their assets to benefit the same heirs – say their children or grandchildren – can coordinate to split assets over two 10-year periods.

For example: John and Jane are a wealthy couple who live in New York City. Their combined annual federal and state income tax is 50%. Their son, Junior, said goodbye to the Empire State and now lives with his wife, Susan, in Florida, which has no state income tax. Junior and Susan’s combined annual taxable income is $50,000.

If John leaves a large IRA to Jane, she will owe 50% tax on every distribution she takes. (While she is not subject to the 10-year required distribution window as his wife, any distributions she does take are still taxable.) But if John leaves enough to Junior to reach – but not exceed – his current tax bracket threshold, those assets are only subject to Junior’s federal income tax rate. John can thus maximize the assets he passes on to family, rather than to the Internal Revenue Service and New York’s tax authorities. After Jane’s death, any remaining IRA assets she owns can pass to Junior. He can then take distributions, presumably still at a lower tax rate, for another 10 years, assuming Jane dies at least 10 years after John.

In a real-life example, there would be more variables to consider. But you can see how this strategy, even in a simplified form, might help reduce the overall taxes on inherited assets.

Note that this technique involves naming your adult child or other intended nonspouse recipient as a primary beneficiary of the account. Primary beneficiaries split the assets in retirement accounts upon the owner’s death. Secondary beneficiaries, sometimes called “contingent” beneficiaries, only receive assets if none of the primary beneficiaries survive the account holder. In the example above, if Junior is a contingent beneficiary for John while Jane is a primary beneficiary, none of the assets from John’s IRA will come to Junior if Jane is still alive at John’s death. The family forgoes the opportunity to create two separate 10-year windows for Junior to take advantage of his lower tax rates.

When naming more than one retirement account beneficiary, bear in mind that you don’t have to split your assets evenly among them. John could stipulate that 70% of the assets in the account go to Jane and 30% to Junior, or any other split he prefers. If you plan for your nonspouse heir to take advantage of a second IRA window from your spouse, you will want to do your best to calculate the amount that the heir should receive the first time around.

As with any financial planning strategy, this technique isn’t right for everyone. If you expect your spouse to need the money in your traditional IRA in the event of your death, you should leave him or her as the sole primary beneficiary. Providing for a spouse’s future security is more important than secondary tax considerations. If your spouse doesn’t necessarily need the assets in your IRA, you can consider the effects of naming one or more extra primary beneficiaries.

Be mindful, too, of your potential beneficiaries’ tax situations. If all your potential beneficiaries are already in the top federal income tax bracket and likely to stay there, you may not need to do anything. In cases where the inherited assets don’t affect the beneficiary’s tax situation, there’s no tax savings to capture by spreading out distributions. This is also why this technique only applies to pretax retirement accounts like traditional IRAs. Roth IRA distributions are tax-free, so there would be no tax benefit to adding beneficiaries.

Savers who have been married more than once should also note that second marriages can cause complications to estate planning, including naming retirement account beneficiaries. For example, if you have children from more than one marriage, you and your spouse will need to discuss your intentions for who gets what. Do not assume your spouse will be eager to name a stepchild a beneficiary without talking it through first.

As this post likely suggests, the decision to name one or more new primary beneficiaries is complex. It’s not something most people should work out on the back of a napkin. If you think this approach may be right for you, talk to a financial planner about it or listen to feedback from another professional you trust. You may need to create projections – or have your adviser create them – to effectively evaluate whether this strategy is worthwhile in your situation. As always, there is no one-size-fits-all answer. But for some savers, the SECURE Act may have created a valuable new retirement planning opportunity.

Managing Vice President Paul Jacobs, of our Atlanta office, is among the authors of our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. He wrote Chapter 12, "Retirement Plans"; Chapter 15, "Investment Approaches And Philosophy"; and Chapter 19, "A Second Act: Starting A New Venture." He also contributed to the firm’s book The High Achiever’s Guide To Wealth.

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