Multi-Gen Planning

Rethinking Distribution Strategy

Simple hacks, outsized impacts

by Jim Barbee

Benjamin Franklin famously warned us that death and taxes were the two certainties of life. However, even a person of his prescience could not envision the complexity of the current U.S. tax code or its propensity for change.

Barring legislative action, a number of provisions of the Tax Cuts and Jobs Act of 2017 will sunset on January 1, 2026. Impacts include essentially halving the estate and gift tax exclusion, increasing the top marginal income tax rate to 39.6% and lowering the top income tax bracket threshold.

Then there are the SECURE Acts. The original Setting Every Community Up for Retirement Enhancement (SECURE) Act became law on January 1, 2020, and changed a number of rules surrounding retirement accounts. SECURE Act 2.0, passed in late 2022, included additional changes to the retirement saving and distribution landscape.

In this complex and evolving ecosystem, helping retirees and pre-retirees leverage their qualified plans in ways that amplify opportunities, minimize hurdles and avoid costly penalties or fees, is central to getting the most out of their retirement planning efforts.

At AuguStar Financial, we receive a number of calls to our Advanced Planning Team concerning qualified plan distributions. With some planning, foresight and a solid understanding of the rules and regulations, it’s not difficult to help clients take full advantage of existing statutes that help maximize their retirement income. Sharing some simple strategies – or hacks – with your clients can position you as a valuable resource for retired clients seeking tax efficiencies when accessing their qualified accounts. Below are a few. One housekeeping note: the term “IRA” will be used as an umbrella term to describe the wider universe of qualified plans – 401(k), 403(b), etc. Unless otherwise indicated, these hacks apply to all qualified accounts.

1.) Name A Beneficiary – The Right One

A common area of confusion surrounds what is known as the “Five-Year Rule,” which dictates the amount of time a non-natural person (e.g., an estate, charity or organization) beneficiary has to take distributions from an IRA. Some people erroneously believe that the SECURE Act extended the withdrawal period to 10 years. The Act did not extend the Five-Year Rule to 10 years. If the original owner had been taking Required Minimum Distributions (RMDs) at the time of death, RMDs must continue based on the single life expectancy of that owner. If no RMDs were being taken by the original owner at time of death, the Five-Year Rule applies. Given this relatively short time frame, naming an estate as beneficiary – which rarely has any benefits – in an account with a relatively short time frame for distribution will likely lead to higher taxes and likely incur higher legal fees, probate fees and other expenses. Even if the IRA is put in a trust that is part of the estate, funds must flow through the trust before heirs will receive them.

2.) Do Not Name A Grandchild As A Direct Beneficiary Of An IRA

The Stretch IRA is no longer an option. The Stretch IRA – not a type of IRA, but a strategy often deployed by owners of IRAs – gave non-spouse beneficiaries the ability to stretch distributions out over their own lifetime. The benefits were clear: it spread the tax liability over a longer time frame while allowing the account more time to grow. Thanks to the SECURE Act, non-spouse beneficiaries must complete distribution of the account within 10 years of the account owner’s death. This change – by compressing the account’s distribution period – was designed to put more money, more quickly, in the U.S. government coffers and has the potential to push beneficiaries into a higher marginal tax rate. There are, however, exceptions to the 10-year force-out for non-spouse beneficiaries. These people are referred to as “eligible designated beneficiaries:”

Beneficiaries who are less than 10 years younger than the IRA owner can still use the lifetime stretch.
Disabled or chronically ill beneficiaries can still use the lifetime stretch.
If a beneficiary is a minor child of the owner, the 10-year force out clock doesn’t begin ticking until the beneficiary reaches age of maturity, which is 18 in most states.

Importantly, this stopping of the clock that applies to children of the IRA owner does not apply to grandchildren. Grandchildren are not considered “eligible designated beneficiaries” under the Secure Act.

While clients cannot put an IRA in a trust while they are alive, they can name a trust as the beneficiary of their IRA. However, trusts as an IRA beneficiary can muddy the waters...

Do clients want to have minor grandchildren receiving what could amount to thousands of dollars in IRA distributions? It opens up tax, trust and legal/guardianship issues. So, the answer is “probably not.”

Clients should not name a grandchild or multiple generations directly as beneficiary of an IRA. If a client wishes to leave money to them, recommend they do so via a trust or guardianship. You should work with your clients and their estate planning attorney to discuss which entity works best for their unique situation.

3.) Not Sure Of An Inherited IRA’s RMD Status? Take An Annual 10% Distribution And Stop Worrying About It

Given the SECURE Act’s inherited IRA 10-year force-out rule, must non-eligible designated beneficiaries (see # 2 above for examples of eligible designated beneficiaries) take an RMD annually or can they take one distribution at end of the 10-year period?

It depends.

If an IRA owner dies after commencing RMDs, and there is only one non-spouse beneficiary, the beneficiary must continue to take at least annual RMD distributions during the 10-year force-out period, based on the longer of the life expectancy of the original account owner or the beneficiary, in order to distribute all funds 10 years after the death of the owner. (If there are multiple beneficiaries – and all of them are non-spouse, non-eligible designated beneficiaries – RMDs are generally calculated using the longer of (i) the life expectancy of the oldest beneficiary or (ii) the original account owner.)

If the owner dies before his/her RMDs begin, only one RMD is required before the end of the 10-year force-out period, though annual distributions are allowed during the 10-year period1.

One timely exclusion: Confusion surrounding the interpretation of the 10-year force-out rule led the IRS to issue NOTICE 2023-54, which states that beneficiaries who should have taken an RMD from such accounts in 2023, but did not, would not be penalized. However, beneficiaries must resume taking RMDs in 2024 and beyond.

Simplify things and take a 10% distribution from the inherited IRA account every year for the 10 years following the death of the owner. This strategy will spread the taxes over a 10-year period and alleviate any confusion as to whether an RMD needs to be taken.

4.) Have Trust Documents Reviewed By Specialists With Expertise In IRA Beneficiary Rules

While clients cannot put an IRA in a trust while they are alive, they can name a trust as the beneficiary of their IRA. However, trusts as an IRA beneficiary can muddy the waters. Most
trust documents have generic – and sometimes outdated – IRA distribution language in them. And in light of recent SECURE Act provisions, with the Stretch IRA strategy unavailable, the language could be interpreted as limiting the trustee to one distribution at the end of the 10th year to satisfy the 10-year force-out rule. Such a scenario is like a tax time bomb. It’s a mis-interpretation that creates a huge tax liability.

It is imperative to have clients’ trust documents reviewed by specialists with particular expertise in this area.

5.) Considering A QCD? Watch The Source Of Funds And The Timing Of The Distribution

Charitable giving has long been a tax-saving strategy for clients taking RMDs. Why? Using a Qualified Charitable Distribution (QCD), clients can satisfy their annual RMD, donate some or all of the funds directly to their charity of choice – removing that amount from their taxable income – and there’s no itemization required.

Four important caveats:

  • Only Traditional IRAs can make a QCD.
  • QCDs must be direct transfers from the Traditional IRA to the charity.
  • QCDs do not count as a charitable contribution for the donor.
  • Once an RMD has been taken, it cannot be re-classified as a QCD.

Why does timing matter? If an RMD is taken prior to making a QCD, that first distribution can’t be offset by the QCD.

These are just five hacks we’d suggest, but there are dozens more that can potentially save clients thousands of dollars in needless penalties, taxes and fees.

With the right guidance, financial professionals can make a big difference for clients taking distributions from their qualified plans. The key is to work with a team of experts that can provide meaningful expertise.

 

 

 

[1] If the beneficiary is a non-spouse, but is an eligible designated beneficiary, and if there are only other eligible designated beneficiaries, the eligible beneficiary can either: (i) use the oldest beneficiaries’ life expectancy in years one through nine or (ii) use the shorter of the original depositor’s life expectancy or the oldest beneficiary’s life expectancy in years one through nine.

 

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