From your very first paycheck to your last retirement withdrawal, the IRS is there — extracting all the cash it’s allowed to grab from you.
Even when you pass on, the taxman still comes to collect his due.
These death taxes diminish your financial legacy, leaving less for your heirs.
Now Congress has shut the door on a popular strategy for keeping your estate intact… effectively creating an all-new death tax.
But luckily, there are still several estate-planning strategies that could reduce your loved ones’ taxes and maximize what you leave behind.
I’ll share some of them with you in a minute.
First, though, let’s look at what’s changed.
RIP Stretch IRA
The Setting Every Community Up for Retirement Enhancement (SECURE) Act has delivered some of the biggest changes to retirement since 2006.
Most of its provisions went into effect on Jan. 1, 2020.
And it opens up an entire new world of financial possibilities for future retirees.
But most of the media attention has focused on one of the negatives of the SECURE Act — the end of stretch IRAs.
Make no mistake — this is a negative. In a lot of ways, it’s like Congress has created a brand-new death tax.
It all comes down to required minimum distributions (RMDs).
As you know, RMDs are money the IRS forces you to take out of your retirement account so it can be taxed as income. The SECURE Act increased the age that RMDs kick in for most people to age 72.
But retirees aren’t the only ones who must worry about RMDs. Anyone who inherits an IRA — at any age — from someone other than their spouse is required to take RMDs from the account.
Under the old rules, those RMDs were set by the person’s life expectancy. The younger the beneficiary, the higher the RMDs. As the beneficiary got older, the RMDs would be reduced.
This allowed the money in an inherited IRA to stretch over the beneficiary’s entire life.
However, these rules had unexpected consequences.
Closing the Door on a Tax Avoidance Scheme
The government set up these rules trying to deplete the account’s value to zero by the time the beneficiary reached their maximum life expectancy.
The problem is that even with the RMDs, the account would continue to grow tax-free. And as the beneficiary grew older, they’d be required to take less money out — accelerating the account’s growth.
So when the beneficiary died, they could then pass the account on to their heir — which could theoretically extend an IRA’s tax-deferred status for generations.
But IRAs and 401(k)s were never intended to be used as vehicles for wealth transfer.
They were designed to encourage workers to save by giving retirement plan participants — not their children or children’s children — a tax break.
So the SECURE Act closed this loophole, mandating that any nonspouse who inherits an IRA must deplete it within a decade of its transfer (unless you meet IRS qualifications as disabled or chronically ill).
This could affect the amount of money you are able to pass along to your kids. But as I said, you do have alternatives you can explore.
While none of these completely matches the tax-deferral benefits of the stretch IRA, each can offer a tax-friendly solution to help meet that goal.
Roth to the Rescue
Converting a portion of your traditional IRA to a Roth can give you some great tax benefits down the road, as we’ve discussed before.
It could also reduce or even eliminate a significant tax bill for your heirs.
If you leave a Roth IRA to your child, they will still have to withdraw the entire account within 10 years of your death. But those distributions will not be taxable since the money was contributed using after-tax dollars.
They can also withdraw earnings from an inherited Roth tax-free if the account is at least five years old when the original account owner passes away.
Of course, remember that the money you convert out of a traditional IRA is considered a distribution — meaning it’s taxable income for that year. So think about the taxes you’ll need to pay and how taking that distribution affects your tax bracket.
Also remember that you shouldn’t plan on withdrawing any of it for at least five years.
Even though you can withdraw any contributions you’ve made to a Roth at any time, the rules are different because this is a conversion. Taking money out early could subject you to penalties.
If you’re still not thrilled about the fact that the money you leave behind must be withdrawn within a decade of your passing, you could choose instead to put your RMDs to good use.
Put Your RMDs to Work
RMDs don’t have to be a curse. They can even help you set something up for your heirs,
For instance, you could use a portion of your RMD to purchase a life insurance policy.
Let’s say you and your spouse have an IRA valued at $500,000. You’re required to take about $20,000 in RMDs each year starting when you are age 72.
You owe about $6,500 in income tax on that distribution. But you could use the remainder to pay the annual premiums on a new $500,000 second-to-die life insurance policy.
It’s just what it sounds like — a policy that pays beneficiaries after both policyholders die.
If one of you dies, the living spouse can continue to receive annual distributions from the IRA.
When you’ve both passed on, the death benefit goes directly to your heirs.
Death benefits aren’t subject to income or estate taxes— so you can effectively leave the money to your kids or grandkids tax-free.
The beauty of this strategy is that the value of your retirement account will be replaced with a life insurance policy paid for with your RMDs. Meanwhile, your remaining IRA account can continue to grow.
If you go this route, though, be aware that you may owe a gift tax.
Premiums paid for children or other beneficiaries are considered gifts. Individuals can give up to $15,000 as gifts without triggering a tax.
Married couples can gift $30,000 per year without incurring a gift tax liability.
So figure out how much the premiums will cost you per year and be ready for a tax hit if they’re over the limit.
The Closest Mimic to a Stretch IRA
If you’d like to have more control over when and how your beneficiaries’ life insurance funds are distributed, you could opt to fund an irrevocable trust with your RMDs.
First, create a trust for the benefit of your family and then purchase a life insurance policy inside the trust.
After that, take your distributions from the IRA and make gifts to the trust that are intended for the annual premium payments on the life insurance policy. You can then set it up to pay a regular income stream to your beneficiaries when you pass away.
Growth in the trust is tax-deferred and the life insurance proceeds are income tax-free and estate tax-free if the trust is structured properly.
Your trust can be structured to provide distributions similar to a stretch IRA — meaning payments can be spread out for as long as there is money in the trust
With planning, that makes it a much better gift for your heirs than an IRA that must be depleted in a decade.
Keep in mind, though, that setting up a trust can be costly and complicated. Be sure you discuss the pros and cons of any estate planning vehicle you are considering with a trusted financial professional or legal adviser.
Wrapping Things Up…
With the elimination of the stretch IRA, the best time to get ahead of the government’s new death tax is right now.
Hopefully you use this information to consider strategies for maximizing what you leave behind to your loved ones.
Here’s to living rich…
Editor, Strategic Retirement