DAVID P. BOEKELOO
David P. Boekeloo, JDDirector, Trust & Estate Servicesview bio

Roth IRAs: A Tax Smart Response to the SECURE Act

9/16/2021

In 2019 the Federal government significantly changed the distribution rules for retirement funds and disrupted estate planning. The solution for many is a micro-Roth conversion. For little tax liability beneficiaries can receive a Roth IRA and not have their inheritance reduced.

The 10-year rule

Father and son walking togetherPrior to the passage of the “Setting Every Community Up For Retirement Enhancement (SECURE) Act” at the end of 2019, the retirement distribution option of choice at the death of the owner of an IRA or retirement account was taking distributions over the life expectancy of the beneficiary. This allowed you to stretch out the income tax liability over several years. Using this strategy generally gave the beneficiary a much greater amount of after-tax dollars.
 
The SECURE Act, however, eliminated this option in most situations and replaced it with a 10-year rule. Now the account must be liquidated within 10 years of the owner’s death, unless the beneficiary is a spouse, a minor, or a disabled or chronically ill individual, or is no more than 10 years younger than the deceased participant. If the beneficiary is a minor, then a lifetime distribution is allowed until the beneficiary reaches life expectancy, and then must be liquidated within 10 years. These new rules can cause substantial income tax liability to the beneficiary. However, a Roth IRA could, with other strategies, reduce this possibility.

SECURE Act Favors Conduit Trusts

Retirement assets left to a trust for the benefit of a beneficiary are even more problematic under the 2019 law. Prior to the SECURE Act, if certain requirements were met, distributions were taken out over the life expectancy of the oldest beneficiary of the trust. There are generally two ways this can be accomplished; a conduit trust or an accumulation trust. With a conduit trust, all the Required Minimum Distributions (RMD) must be paid out immediately to the trust beneficiary, who must pay tax on the distribution at their tax rate. With an accumulation trust, the RMDs can either be paid out to the beneficiary (who would pay the tax at his/her rates) or kept in the trust and have the tax paid at accelerated trust tax rates. Under the prior law, either type of trust could be chosen and receive the lifetime distribution option. However, with the SECURE Act all trusts, except for trusts for the benefit of the disabled or the chronically ill, must be conduit trusts to achieve the greatest distribution allowed. If an accumulation trust is chosen, then all distributions would have to be made within five years. Here’s an example:
 
Grandfather fishing with his 15-year-old grandsonSteve Grantor leaves his IRA to a trust for the benefit of his minor child, who is 15 years old. If a conduit trust were chosen, distributions could occur over the life expectancy of the minor child until the child reaches the age of majority; at that time the remainder would have to be paid out within the next ten years. Susan Grantor leaves her IRA in a trust for the benefit of her adult child; if a conduit trust is chosen, the IRA must be liquidated within ten years, but if a accumulation trust is chosen, all payments must be made within five years of the death of Susan. The only exception would be if the adult beneficiary was disabled or chronically ill. In that case, an accumulation trust could be chosen and taken out over the disabled person’s life expectancy. One important difference between an accumulation and a conduit trust is that when the distribution period ends (generally ten years) for a conduit trust, all the retirement plan must be paid out to the beneficiary, whereas with an accumulation trust, it can stay in the trust. Assets that remain in a trust can be much more beneficial from an asset-protection standpoint, such as when the beneficiary is a spendthrift or involved in a troubled marriage.

Maybe a Roth Conversion is the Answer?

The downside of being forced to take a distribution from your IRA or retirement plan by year ten, instead of over the life expectancy of the beneficiary, is that the income taxes are no longer deferred. This means that the beneficiary would receive much less money than from a present-value approach.
 
One potential solution is to do a Roth conversion prior to your death. Any amounts left to a trust that are in a Roth will generally be tax-free when received by the beneficiary.
 
Here’s an example of the power of having a Roth left to a beneficiary, as opposed to a traditional IRA or retirement plan. Sam Decedent dies with an IRA worth $1 M, which he leaves to his daughter, Sarah. She decides to wait the full ten years before liquidating. The IRA has grown to $2 M. Assuming Sarah is in the 40% tax bracket, she will pay $800,000 in federal incomes taxes, leaving her with $1.2 M. If on the other hand, if the IRA were a Roth, the full $2 M would not be taxable, leaving her with an additional $800,000. Clearly, it is much better to be the beneficiary of a Roth than a traditional IRA.

Balancing a Roth IRA on a level

Considerations For Making a Roth Conversion

Roth conversions are advantageous to the beneficiary, but taxable to the owner. The best strategy is to do micro-Roth conversions so that the least amount of tax is payable in any one year.
 
A micro-Roth strategy is one where the owner does an annual Roth conversion for an amount that would keep him/her in the same income bracket.  The risk of doing micro-Roth conversions is that you could die too soon, so it is best to hedge that risk by the purchasing a life insurance contract. If the owner dies prior to the completed Roth conversion, the insurance policy would be used to pay the tax on the unconverted Roth. An example demonstrates how this would work.
 
Father and daughterRon Diedrich, age 60, has a $1 M IRA, which he is going to leave to his wife Betty, who will in turn leave it to their daughter Janet. Betty has plenty of money other than the IRA to live on. Ron decides to convert $50,000 a year to a Roth, because that will keep him in the same tax bracket. He buys a survivorship policy on his and Betty’s lives as a hedge against the micro-Roth strategy becoming incomplete. If Ron dies first, he will leave the IRA to Betty and she will continue the micro-Roth strategy. No matter the order of death, Janet will receive all IRA assets without having any income tax liability, either because it is in a Roth or because the death benefit from the insurance policy would be used to pay the income tax liability he would be responsible for when taking a distribution from the IRA that has not yet been converted.
 
The second consideration you might have when making a Roth conversion is whether you desire to make all the retirement assets payable to a trust for the benefit of several children who are in different income brackets. Distributions from a trust are taxable to beneficiaries at their income tax brackets, and the trust gets a corresponding distribution deduction. Consequently, distributions from a Roth will be tax-free to the beneficiaries if it is the trust’s only asset, while distributions from a traditional IRA would be taxable at the beneficiaries’ tax rates. Generally, you want any Roths to be payable to a trust for the child in the highest tax bracket, and purchase insurance as a hedge if that is possible. If not, you need to know which children are likely to be in the highest tax bracket so you can leave the Roth for their benefit.

The third consideration is when the only significant asset is an IRA that is needed to fund a Special Needs Trust (SNT) for a disabled beneficiary. IRAs left to a disabled beneficiary can be paid out over the beneficiary’s life expectancy in an accumulation trust. .
 
Young man in a wheelchairIn a special needs trust, money can be distributed to the disabled individual (if needed) to supplement what state and federal programs pay. If the money is just used to supplement, then it does not disqualify the beneficiary from receiving government aid. Leaving a traditional IRA to a SNT can cause significant income tax problems, though. Many years no distributions (or very few distributions) will be paid from the SNT to the beneficiary because they are not needed. At the same time, because the IRA distributions must be distributed to the trust over the beneficiary’s life expectancy, any undistributed amount would be taxed to the trust at very accelerated income tax rates. If this occurs, it could cause substantial diminution of trust assets, making it so the special needs child would not receive the supplemental distributions, if needed, and there may be very little money left over at the special needs child’s death to pay the remainder beneficiaries.
 
The solution to this problem is to do a series of micro-Roth conversions. If the only asset a SNT receives is a Roth, then there will be no income tax liability on the annual distributions, whether they are paid to the special needs child or retained by the trust. As always, you should consider whether a life insurance policy could be purchased to hedge against early death.

Micro-Roth Conversions are the Answer

The SECURE Act significantly altered estate planning for retirement assets. The option of choice for the stretch IRA is no longer available. Instead, in most cases retirement plans and IRAs must be liquidated within ten years. This causes significant income tax liability to the beneficiary, which means their inherited amount will be much less. The solution to this problem is the micro-Roth conversion, where for little tax cost the beneficiary can receive a Roth IRA and not have his inheritance reduced.
 
If you have questions or would like more information on implementing Micro-Roth Conversions please reach out to an experienced RINA professional.

Disclaimer:
This content is prepared solely to provide general information to our clients and community.

This content does not constitute accounting, tax, or legal advice, nor is it intended to convey a thorough treatment of the subject matter.

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