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After the SECURE Act: Rethinking Generational Wealth Transfer

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After the SECURE Act: Rethinking Retirement Planning and Estate Planning Strategy for Generational Wealth Transfer

The SECURE Act became law on December 20, 2019. “SECURE” stands for “Setting Every Community Up for Retirement Enhancement.” As the name suggests, the SECURE Act influences how people save, plan for, and live during retirement, and how they transfer wealth to the next generation.

In particular, the SECURE Act has changed the rules that govern two classic elements of estate planning, wealth transfer, and retirement planning:

1. Tax planning

2. The “Stretch IRA”

The SECURE Act impacted tax planning by changing the rules for “required minimum distributions” (RMDs). With revamped rules that highly restricted the Stretch IRA, the SECURE Act effectively eliminated this great and easy-to-implement estate planning strategy.

These rule changes need to be incorporated into both retirement planning – especially as it relates to retirement income – and estate planning. These changes also require a fresh look at other tools that can optimize both. Here are some issues you should consider.

Rule Change 1: the Age for Required Minimum Distributions

Once people reach a certain age – the “required minimum distribution age” – they are required to withdraw a minimum amount from retirement accounts like an IRA or 401(k). This age was 70½ before the SECURE Act, but the passage of the Act increased it to 72 for people who would turn 70½ in 2020 or later. Those people now enjoy an additional 18 months of delay before they have to start taking withdrawals. The effect of the extra saving on a retirement account can be significant. Furthermore, the 18 months of delay also means 18 more months that a retiree doesn’t have to pay income tax that withdrawals would generate – another major advantage in many instances.

However, for people with significant wealth in qualified plans, the later date also means larger RMDs, which is a potential escalator to higher tax brackets and Medicare expenses.

Rule Change 2: the Gutting of the “Stretch IRA”

For many years, estate planning has enabled people to arrange for their IRA accounts to be transferred to a beneficiary after they pass away. In particular, for people who died before 2020, beneficiaries could elect to “stretch out” the taking of withdrawals from the IRA over the rest of their lives; hence, the term “stretch IRA.” Stretch IRAs are advantageous in that taking smaller withdrawals over a longer period enables beneficiaries to reduce their annual tax bills. It was an easy and effective way to create a tax-efficient stream of retirement income for the next generation.

The SECURE Act, however, mandates that for people who die after 2019, beneficiaries – with some exceptions – must take all withdrawals from the account within tenyears. For most beneficiaries, that means taking larger withdrawals over a shorter period, with the consequence of a raised annual tax bill, possibly also from having been nudged into a higher tax bracket. Demographically, many beneficiaries will receive their IRA inheritances at the peak of their earnings – also a tax-increasing effect.

There are exceptions (including a surviving spouse, a minor other than a surviving grandchild, a chronically ill or disabled person, and a person within ten years of the original account owner’s age). But that leaves a lot of other beneficiaries for whom the SECURE Act will have eliminated the benefits of the former Stretch IRA. 

Impacts of the Rule Changes on Retirement Planning and Estate Planning Strategies

The SECURE Act’s elimination of the Stretch IRA for almost all non-spouse beneficiaries was a huge tax grab. Clearly, it’s an attempt to force inheritors to withdraw more money faster and pay more taxes while many of those beneficiaries are at the height of their careers and their tax rates are at their peak. So where passing on a large IRA used to be a fairly straightforward method to transfer wealth, the new rules, with their higher tax implications, make it more attractive to consider alternatives as part of your planning – in particular, life insurance.

It’s always important to be skeptical when it comes to life insurance because it comes with high expenses, and so many of the product offerings are mediocre. But the SECURE Act makes it prudent to revisit the pros and cons.

Here’s why.

First, life insurance has certain definite tax advantages. Death benefits are income tax-free. Cash values inside a policy can appreciate tax-free and can be withdrawn tax-free, provided that rules are followed, and the policy is not allowed to lapse. Those are important considerations for retirement income and retirement planning overall. From an estate planning perspective, when life insurance is inside an irrevocable trust, its death benefits are usually free of estate taxes – in addition to being income tax-free. And there also can be an inherent leverage in a life insurance policy, which allows relatively small amounts of after-tax dollars paid upfront as premiums to turn into relatively large amounts of tax-free dollars in the future. When interest rates are low, this leverage can represent a significant estate planning and retirement planning opportunity.

Second, governments are increasingly focused on taxing other assets that have traditionally been used to transfer wealth. Life insurance, for a number of political and sociological reasons, is not a target in the same way. In fact, 2020 legislative changes made the tax advantages potentially more lucrative. Hence, these trends in tax policy may make life insurance relatively more attractive than in the past.

As always, be skeptical. There are a lot of concepts involving insurance which are a bad deal for everyone but the salesman. Always seek out a quantifiable, bottom-line benefit. Always do your due diligence.

That said, when it comes to estate planning and retirement planning, the SECURE Act has created new challenges and new opportunities where carefully utilized life insurance may be a component of the solution.

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