Addressing the 10-year hitch in pretax retirement plans

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Good news for non-spouse beneficiaries of tax-deferred retirement accounts: thanks to the 10-year rule in the Secure Act passed into law late last year, most will avoid annual required minimum distributions for deaths occurring after 2019.

But there’s a hitch: This RMD hall pass for surviving beneficiaries requires these inherited accounts to be emptied by Dec. 31 of the 10th year following the year of death. Failure to comply could trigger a 50% penalty; a full withdrawal after 10 years of compounding could produce a huge lump-sum of taxable income.

“We are in a unique time period for planning for pretax retirement accounts,” says Sheryl Rowling, founder of wealth manager Rowling & Associates and head of rebalancing solutions at Morningstar.

“Not only is the 10-year rule now law, we have historically low tax rates that will surely increase — possibly as early as 2021 and no later than after 2025 — when the current rates sunset.”

While the getting is good

If tax rates seem likely to rise, advisors may recommend moving money from tax-deferred accounts earlier than necessary.

“Our first choice is executing Roth conversions,” says Bud Kahn, planner, accountant and founding principal of Wealth Management Strategies. A couple with taxable income of, say, $50,000 could convert $30,000 to a Roth IRA and owe only $3,600 in federal income tax, at 12%. (See table.)

Kahn also now recommends IRA withdrawals to fund a permanent life insurance policy owned by an irrevocable trust. This approach will ultimately pay an income tax-free death benefit to heirs and possibly keep the policy from the insured individual’s taxable estate.

Sooner than later

Will clients accept withdrawing money earlier than necessary from pretax accounts? In Kahn’s experience, yes — if presented properly.

“Our high-net-worth and ultrahigh-net-worth clients concur with our opinion that their tax rates will never be lower than they are now. They expect that the tax rates for their beneficiaries also will be higher,” Kahn says.

Jaime Ruff, principal at wealth manager Homrich Berg, tells of a 68-year-old client with an extremely large IRA but low current income. Under the 10-year rule, the client’s children eventually will inherit the IRA and take distributions.

“We discussed the negative tax consequences of that income being compressed into fewer years [and therefore] bumping the kids into a higher tax bracket,” reports Ruff. He says that the client has agreed to start IRA distributions, now at a lower-income tax rate than he probably would face if he waits until age 72, when RBDs begin.

Other strategies suggested by Ruff include having clients use pretax IRA funds for charitable donations — designating charities rather than individuals as beneficiaries of IRAs and using multigenerational trusts as IRA beneficiaries in order to spread reported distributions over more income tax returns.

If a trust is beneficiary of a pretax account, the trustee can oversee a tax-efficient distribution schedule and ensure avoidance of the 50% penalty.

Prudent payouts

Although clients who own pretax accounts may welcome savvy planning for the future, others might need immediate advice after inheriting an account that’s subject to the 10-year rule.

“For clients who fall under the new rules, we’ll come up with a distribution game plan that suits their situation,” says Mark Wilson, founder of MILE Wealth Management.

Wilson gives the example of a 25-year-old beneficiary just entering the workforce. “I’d likely accelerate withdrawals from the inherited account to top off the 10% or 12% tax bracket,” he says.

Alternatively, for a 60-year-old beneficiary who plans to retire at 65, Wilson might defer distributions until retirement and then use the inherited IRA to supplement spending needs before Social Security and RMDs begin.

Generally, Wilson says, if a client dies and leaves a pretax account to a non-spouse, he may discuss distribution planning with the beneficiaries.

“I’ll offer to continue helping heirs I’d like to work with,” Wilson says.

The 10-year rule provides an incentive for the next generation to keep our services going,” Rowling says.

Indeed, for advisors serving the next-gen beneficiaries of pretax accounts sagely can be the key to maintaining all-in-the-family relationships.