The Great Wealth Transfer: IRA Management for Today and Tomorrow

The Great Wealth Transfer

We are currently in the middle of the Great Wealth Transfer in the United States. According to a research report done by Cerulli Associates, $84.4 trillion in wealth will be transferred from households to heirs and charities between 2021 and 2045.¹

Many of these dollars will reach beneficiaries in the form of inherited traditional IRAs, Roth IRAs and 401(k) accounts.² 

The Great Wealth Transfer, Taxed

Losing a loved one can be and frequently is emotionally challenging for individuals and families. Receiving an inheritance can sometimes ease the financial burden of estate administration, funeral costs, and other financial hardships. Unfortunately, the administration of the inheritance is not always straightforward and can be tangled with frustrating and confusing tax consequences.  

To make matters more complicated, changes made by the SECURE Act in 2020 and the creation of the “10-year rule” have created confusion on how to best manage distributions from inherited IRAs. Legislation surrounding these distributions and the new 10-year rule is still in flux. Having a financial advisor and CPA on your team can help manage the tax consequences of these distributions.

Tax-Savings Strategies for Inheritors

For this article, we are focused on non-spousal, designated beneficiaries. Spousal beneficiaries and eligible designated beneficiaries will have different considerations. If you are not a spouse or an eligible designated beneficiary, your inherited IRA is subject to the 10-year rule. While distributions from an inherited Roth IRA are not taxable, distributions from an inherited traditional IRA are taxable and can significantly change your tax situation; they should be handled with care.  
Currently, the only requirement on inherited traditional IRAs is to distribute the full amount within 10 years. Pending legislation may force inheritors to take a certain amount each year, and failure to distribute the minimum amount can result in a 10%-25% tax penalty. For now, the IRS has waived required minimum distributions from these accounts from 2020 through 2024.

To avoid penalties and minimize taxes, inheritors will need to monitor legislative changes. For now, using the 10-year rule strategically is likely the best way to mitigate tax consequences. A few examples of this include:  

• If you plan to retire within the 10-year window, weighting distributions post-retirement can help avoid a dramatic change in your income tax bracket.  
• If you have a significant taxable event (such as a liquidity event from the sale of a business or property) planned within the 10-year window, consider minimizing distributions during the year of sale.   
• If you plan to start Social Security in the 10-year window, your tax bracket may be lower now, relative to when you begin to draw Social Security. While taking distributions earlier means you surrender the tax advantages of an IRA, the benefit of reduced taxes may be more advantageous.  
• If you have your own IRA and you begin required minimum distributions within the 10-year window, it’s important to be mindful of these distributions and what your total tax burden might be during that initial year.   
• If you inherit an IRA and are charitably inclined, you can use the distributions to make annual donations, provided you are over age 70 ½. These distributions are not taxable, though they are not deductible either.  

As you can see, there are many ways to plan strategically around the 10-year rule. Depending on your specific situation, a financial advisor and accountant can best advise you on how to maximize your benefit.

Tax-Savings Strategies for Current Account Holders

If you plan to leave assets to the next generation, be sure to carefully consider the types of assets you’re leaving behind. Not only is having a strategy important, but your choices will impact how much of your assets an heir is left to enjoy and what they end up paying in taxes.

Roth IRAs 

During your lifetime, Roth IRAs do not have required minimum distributions. The dollars contributed are taxed, then the funds grow tax-free in the account, and distributions are ultimately also tax-free (with a few exceptions). That makes these funds distinct from traditional IRAs, which are funded with pre-tax dollars, grow tax-free, and distributions are taxable and required starting at age 73.

Conversions are widely used today to avoid taxable, required minimum distributions from traditional IRAs. Taxes are paid at the time of conversion. While they do not make sense for everyone and the benefit of a conversion depends on your current and future income bracket, when considered as an estate planning tool, Roth conversions can significantly benefit the next generation. Distributions required by the 10-year rule are not taxable in an inherited Roth IRA, as opposed to an inherited traditional IRA.

Many individuals now have access to Roth 401(k)s through retirement plans. Unlike traditional Roth IRAs, there is no income limit to contribute to these accounts. If your income has been reduced due to scaling back at work, job changes, etc., it may be worth considering contributing to a Roth 401(k) to build your assets for the next generation. It does not provide the same benefit as a traditional 401(k) contribution but may make sense for you depending on your goals.

Spending Down Accounts

Because IRA dollars grow tax-free until distribution, there is an enormous benefit to leaving these accounts to grow through market cycles. However, when it comes to passing dollars to the next generation, taxable accounts receive a “step-up” in cost basis, eliminating any taxes associated with capital gains. At the time of your passing (and depending on the titling of the account), a taxable account may have significantly less tax impact on your next generation relative to an inherited IRA with taxable distributions—especially if your next generation will have significant income within the 10-year window following your passing. In that event, spending down your IRA during your lifetime may make more sense than utilizing a taxable account.

Prepare Your Beneficiaries

While these conversations can be challenging, having an open and honest conversation with your heirs or beneficiaries can help eliminate tax burdens for you and for them. A financial advisor can mediate these conversations and help you decide what makes the most sense for you and your family.  
 
When thinking about these types of accounts, both pre- and post-inheritance, it is important to have an experienced team in place to help manage the tax consequences. That team should include a trusted financial advisor and a CPA. Including these professionals in your conversations with the next generation can help facilitate a smooth transfer of wealth and accounts, as well as help mitigate tax consequences. Reach out to a Curi RMB Capital advisor with any questions.