Transferring Wealth: IRAs Are a Bad Option
Key Points – Transferring Wealth: IRAs Are a Bad Option
- The SECURE Act Ensured That Your IRA Assets Are No Longer Secure
- The Three Beneficiary Designations from the SECURE Act
- SECURE 2.0 Did Some Good Things, But Not Related to Transferring Wealth
- Where Should You Be Saving and How Much Should You Be Saving?
- 14 Minutes to Read | 34 Minutes to Listen
What Do You Need to Consider When Transferring Wealth?
Do you remember when IRAs were good? Congress messed that up with the SECURE Act. IRAs are now a bad wealth transfer option. Dean Barber and Bud Kasper will help explain why that is and what all to consider when transferring wealth to your loved ones.
The SECURE Act Made IRAs a Bad Option for Transferring Wealth
Do you remember when IRAs were a legitimate estate planning vehicle and good for leaving a legacy? Well, that’s no longer the case. IRAs are a bad option for transferring wealth. Why is that? It’s because Congress messed it up when it created the SECURE Act.
“Ever since the SECURE Act was passed, I’m not feeling so secure with my IRA assets. And neither should anyone else. They turned into the worst estate planning asset to pass to the next generation. I would say that IRAs are on life support after the SECURE Act.” – Dean Barber
So, Congress then passed the SECURE Act 2.0 in December to try to revive IRAs. There were some positive things in SECURE 2.0, but it didn’t do anything to resolve the issue with IRAs no being a bad option for transferring wealth. If you’re inheriting an IRA or own an IRA that’s going to transfer wealth to the next generation, you need to understand the rules about inheriting IRAs.
We’re Thankful for Our Good Friend, Ed Slott, Who Is America’s IRA Expert
The rules for inheriting IRAs are far from simple thanks to the SECURE Act. However, we’re fortunate to have a close relationship with America’s IRA Expert, Ed Slott, to make sure that our team has a good understanding of those complicated rules. And then, it’s our responsibility to pass that knowledge along to as many people as possible. Those rules are critical in the retirement planning process.
We’re going to provide some valuable insight from Ed shortly. But first, we want to help you understand how Congress messed up the IRA as a good option for transferring wealth with the SECURE Act. And when we say IRA, we’re talking about 401(k)s, 403(b)s, and all other tax-deferred assets.
The Three Beneficiary Designations
The SECURE Act created three classes of beneficiaries: eligible designated beneficiaries, non-eligible designated beneficiaries, and non-designated beneficiaries. Each of those classes of beneficiaries have different rules how they must take money out of IRAs once they inherit it. And if you get it wrong, there are going to be penalties involved, so it’s important to understand these rules.
A non-eligible designated beneficiary are all designated beneficiaries who don’t qualify as eligible designated beneficiaries. If you don’t qualify as an eligible designated beneficiary, you are a non-eligible designated beneficiary. So, what is an eligible designated beneficiary?
An eligible designated beneficiary is a surviving spouse, minor children of the account owner that are under 21, disabled individuals under strict IRS rules, chronically ill individuals, and individuals who aren’t more than 10 years younger than the IRA owner. Siblings oftentimes fall within that last example if they’re not more than 10 years younger than the IRA owner.
Inheriting an IRA … and a Tax Nightmare
Why is this important? The average life expectancy in the United States is 76.1 years old. So, let’s run through an example. Let’s say you pass away at 76 and your son or daughter inherits your IRA. They’re likely going to be in their mid 40s to early 50s, so they’re in or getting close to their peak earning years. They’ll be in the highest tax bracket that they’ve ever been in. The SECURE Act forces them to take all the money out of the IRA within a 10-year period following strict rules.
It’s crucial that you’re working with a CFP® Professional and CPA who work together on your financial plan that can revive your IRA and make it something that is feasible to transfer wealth to the next generation.
Some Keen Insight from America’s IRA Expert
As promised, we want to share with you some important knowledge about IRA rules and transferring wealth that we’ve learned over the years from Ed. Ed has joined Dean on The Guided Retirement Show on three separate occasions. You can check out those three episodes below.
- How to Avoid the Biggest Tax Traps with Ed Slott
- Creating a Tax-Free Retirement with Ed Slott
- Ed Slott in Studio!
Hold on to Your Wallets!
And we’re excited for Ed to be joining us again on The Guided Retirement Show in a couple of weeks. Ed and Dean plan to discuss SECURE 2.0 in great detail. Here’s a quick excerpt from a previous episode from Ed that highlights his high-level thinking.
“Whenever Congress names a tax law, you can almost always bet that whatever they name, it will do exactly the opposite. (The SECURE Act) means that you’re not secure. When you see a tax bill called the SECURE Act, hold on to your wallets. They’re coming for you. And that’s exactly what they did.” – Ed Slott
Understanding Who Is and Isn’t Forced to Abide by the 10-Year Rule
By passing the SECURE Act, Congress is causing money that’s in your IRA to transfer to the next generation to be forced out over a 10-year period. Now, you’re going to pay higher taxes on it than what it was most likely deferred at when the money was put into a 401(k).
The Required Beginning Date
It should be noted, though, that there are some people who don’t need to abide by the 10-year rule. Eligible designated beneficiaries can still stretch as if the SECURE Act never existed. Everyone else is still forced to get the money out over a 10-year period. But here’s the question. Do you need to take some money out every year or can you defer all the distributions and take it all out in that 10th year? Well, it depends.
Here’s the kicker. If the individual dies before their Required Beginning Date, the non-eligible designated beneficiaries can choose to defer Required Minimum Distributions until the 10th year. Ten years is the max. You’re just not forced to take RMDs every year. But what is the Required Beginning Date?
A Change in the Required Beginning Date
It’s different now than it was last year. It’s now April 1 of the year following the year that you turned 73. Your RMDs are still 73 or April 1 of the year following. But if you wait until April 1 of the year following, then you need to take two RMDs in that year. Then, on January 1, 2033, it goes up to 75.
“It’s grossly complicated. There are tons of mistakes that are made on this. And there are penalties that come with those mistakes. If you don’t know how to manage around it, you can easily make those critical mistakes.” – Bud Kasper, CFP®
But what happens if someone dies after their Required Beginning Date? In that case, non-eligible designated beneficiaries need to take RMDs every year and all the money must be out by the end of the 10th year. If you’re going to transfer wealth to your beneficiaries via IRAs, are they eligible designated beneficiaries or non-eligible designated beneficiaries?
Far too many people don’t even think about RMDs as they begin to plan for retirement. Don’t be one of those people. Considering RMDs is included in our Retirement Plan Checklist, which is designed to help gauge your retirement readiness. Download your copy below!
A Tricky Situation with Trusts
And if you have a trust that is a part of the beneficiary designation of your IRA, you need to be even more careful. Due to the SECURE Act, they will disqualify and call it a non-designated beneficiary if your trust happens to be the beneficiary of the IRA and has a provision for part of the money that’s within the trust to go to a charity.
“Most of the people I know that have trusts have a portion of it going to a charity or multiple charities. Now, if your IRA goes in there, you’re going to be disqualified and it’s going to mess up everything. You need to go back and figure out what you should do. Do you need to redo your trust or redo the way that your beneficiary designations are set up?” – Dean Barber
It’s Not About How Much You Make … It’s About How Much You Get to Keep
You need to do one of those two things because if you don’t, there are going to be unintended consequences. Uncle Sam has his hand out and is ready for you to make a mistake. Don’t be that person. Remember that it’s not how much you make; it’s how much you get to keep. You need to work with financial professionals that understand these rules and keep as much of your money as possible.
It’s America Saves Week Next Week, but We Celebrate It Every Week
Speaking of how much you get to keep, let’s talk about saving. Did you know that next week is America Saves Week? It’s an annual celebration that serves as a call to action for Americans to commit to saving. Information about America Saves Week and other important dates that impact your retirement are noted on our 2023 Retirement Planning Calendar, so make sure to download your copy below.
Where Should You Be Saving to?
We do our best to celebrate America Saves Week every week. The question you need to ask yourself when it comes to saving is an important one—where should you save your money? There are three different buckets that you can save too, and we’ve mentioned one of them. You have the option of saving to tax-deferred, taxable, or tax-free accounts. Dean has one very important takeaway before explaining each of the buckets.
“You should never put your money into something until you know the rules of getting your money out. Should you save into a taxable account? Should you save into a traditional 401(k) or IRA, where you get a tax break now? Or should you save into a Roth 401(k) or IRA, where you pay taxes on the money before it goes in and you get tax-free growth after that and when you take it out.” – Dean Barber
To help get a better idea of where you should be saving, download our 401(k) Survival Guide below. It will help show you that how you should be saving will be different than how your friends should be saving.
And How Much Should You Be Saving?
Now that Dean has briefly explained those three buckets, there’s another important question to ask in addition to where should you be saving. That is, how much should you be saving? You’ll find that the only way to determine that is to create a comprehensive financial plan.
We use a program called the Guided Retirement System that tells us how much you need to save based on the resources you have today and how much you want to spend in the future. Then, it will give you a probability of success of being able to achieve your goals. It provides you a lot of clarity on how much you need to retire.
The Rothification of America
When people ask Bud where they should be saving to, it doesn’t take him long to give an answer. If you know Bud, he’s a big believer in the Roth. This is one area that SECURE 2.0 was very helpful, as it created opportunities for people to get more money into Roth IRAs, 401(k), SEPs, and SIMPLEs. We call this the Rothification of America.
But why would Congress want to have more money going into Roth IRAs as opposed to traditional IRAs? It’s because they’re getting they’re getting the taxes immediately when people pay the tax on the Roth before putting it in.
“The short-sidedness of Congress could be good for you. The only way it could be bad for you is that if in 10, 15, 20 years from now, we go away from an income tax and go to a national sales tax where you’re taxed based on what you spend, not on what you earn. That would then blow up any of the Roth money.” – Dean Barber
People might think that if they put their money in the Roth and pay taxes on it before it goes in and take it out tax-free, but what if they eliminate the income tax and go to a sales tax? That means they would pay taxes on everything they buy in the future and pay taxes on the money before it went in. So, those people might just choose to save to the traditional and get their tax break. Let’s see what Bud thinks, though.
“I would always err on the side of not being taxed over the chance that I would be taxed.” – Bud Kasper
The Roth Match
Another thing that SECURE 2.0 did was give employees the option to make the matching contribution to the Roth portion of their 401(k). But don’t ask your employer if that’s available yet because it’s not. Dean believes that the earliest it will be available is 2024. Your employer needs to amend the plan document first. That’s going to be a challenge for employers, but it’s still progress.
“In the Roth account, everything comes out tax-free. When we do planning and look at the amount of income that someone needs, having that income without taxation can let us do a better job for our clients. It’s a beautiful thing.” – Bud Kasper
The Best Part of the Tax Code
Bud and Dean are in agreement that the best part of the tax code is the Roth IRA written by former U.S. Senator William Roth in 1997. The Roth IRA is the answer to a lot of these issues. Even if you’re forced to take the money out over a 10-year period in a Roth IRA, there’s never a Required Beginning Date, which means there’s never any RMDs for the original Roth IRA owner.
That means that the beneficiary doesn’t need to take any money out until the 10th year. And then they can take it all out tax-free after getting another 10 years of tax-free growth. So, be kind to your beneficiaries and Roth your IRA and do Roth conversions in very methodical ways.
“When we’re doing financial planning for people—whether they’re in their 50s, 60s, 70s, etc.—we’re not just looking at how that financial plan is going to affect them during their life. We’re also looking at how their wealth is going to transfer to the next generation in the least taxing way possible.” – Dean Barber
The Two C’s with the Roth: Contributions and Conversions
Over the past decade, we’ve continued to see people do more Roth conversions. In many cases, Roth conversions make sense and they can be helpful when transferring wealth. Bud likes to think of the two C’s when it comes to the Roth: Roth contributions and Roth conversions.
“You should be doing both. If you did it early enough, you hopefully won’t have the conversion issue that we have to deal with when people are retired. We look into Roth conversions because it’s a more effective way to get distributions.” – Bud Kasper
Pay Attention When You’re Considering Roth Conversions
We can’t stress enough, though, that Roth conversions need to be methodical. And in some cases, they might not make sense for you at all. Dean recalls a situation last year where he met with someone who was looking into doing a Roth conversion. She wanted to convert $50,000 of a traditional IRA to a Roth IRA and was already receiving Social Security.
Dean ran the numbers and found out that doing a $50,000 Roth conversion would make it so that she would be paying taxes on $75,000. The Roth conversion would have made $25,000 of her Social Security taxable that wasn’t before. So, she wound up doing a $10,000 Roth conversion so that more of her Social Security wouldn’t become taxable.
“When you’re doing Roth conversions, we suggest that you do them methodically. Don’t set out some set-it-and-forget-it plan where you’re doing a certain amount each year. October is the ideal time to look at how much you should be converting and if you should be converting.” – Dean Barber
Considering Your Current and Future Tax Brackets When Transferring Wealth
Let’s say you’re in the 22% tax bracket and you have another $15,000 that you can earn without going into the 24% bracket. You might want to do that if you look forward to when your RMDs start and you’ll be in a higher tax bracket.
Everybody is going to be in a different situation. Our Guided Retirement System that we mentioned earlier is designed to look forward to see what your tax rate is going to look like at 73 when RMDs come into play. Are you going up into a higher bracket at that point? Will a Roth conversion cause your Medicare premiums to be permanently higher? All those things need to be considered when looking into Roth conversions.
Striving to Get the Best Outcome for You
Dean and Bud also can’t stress enough that having in-house CPAs that work alongside our CFP® Professionals has been a game changer. That allows us to have the planning and the tax planning working together to orchestrate the best outcome for our clients.
People can oftentimes think that a CPA is there to prepare your taxes. But anyone can prepare your taxes. Tax preparation is a commodity. Tax planning requires advanced skills from the CPA and a financial plan that’s already prepared by a CFP® Professional. That way, the CPA that’s doing the tax planning can look at the plan from a tax perspective.
When you marry those things together, that’s when the magic starts to happen. That’s when our clients start to see the tax savings that can happen over time.
“We maximize the net results—free of taxes—for the distributions that our clients would need. To give you a sense of how this happens inside our office, we have the plan developed and a CPA joins the CFP® Professional that built the plan. We have a charts that show that if we convert a certain amount, how would your Social Security and Medicare premiums be impacted. We go on to a larger amount of conversion until we find what’s best for you. When you have that visual in front of you, it becomes a very easy process.” – Bud Kasper
Increases in Contribution Limits
We’d also be remiss if we didn’t mention the big increases in retirement plan contributions that are available in 2023. Make sure to check out our Finance in Five video on the 2023 retirement plan contribution limits with Logan DeGraeve, CFP®, so you can make the most of your contributions.
One of the big retirement plan contribution limit increases involves the Simplified Employee Pension plans. You can now save to a Roth SEP as well, which is a new option with SEPs. The same goes for SIMPLEs (Savings Incentive Match Plan for Employees) as well. SEPs are typically for self-employed individuals. They aren’t widely used, but it’s an option that sole proprietors and some small businesses need to know about.
529 Plans and Qualified Charitable Distributions
And if you’re trying to help fund your children’s or grandchildren’s educations, you should know that starting in 2024, a 529 plan can also be rolled into a Roth IRA if they don’t use it all. That can give them a head start on saving for retirement.
And we got close to touching on this earlier, but if you’re charitably inclined, don’t forget about Qualified Charitable Distributions when you’re looking into transferring wealth. The rules with QCDs didn’t change due to the SECURE Act or SECURE 2.0. QCDs become an option for you once you turn 70½. They have been a very popular tax planning tool since the personal exemption went away and the standard deduction is higher. So, it makes sense for charitably-inclined people who are 70½ and older to give directly from their IRA via a QCD.
Transferring Wealth Starts with a Financial Plan
The bottom line is that financial planning is much more complex than just your investments. Yes, your investments are important, but they’re only a part of your financial plan. You also have taxes that we’ve thoroughly discussed, risk management (your insurance), and estate planning, which is really at the center of what we’ve been talking about with transferring wealth to your loved ones.
As we hope you’ve started to realize in this article, those core components of a financial plan are intertwined. You can really begin to see how they’re intertwined and how it all relates to your unique situation by using our financial planning tool. It’s the same tool that our CFP® Professionals use with our clients, and you can use it at no cost or obligation. Just click the “Start Planning” button below to begin building your plan today.
And if you have questions about transferring wealth or other aspects of financial planning, let us know. By clicking here, you can schedule a 20-minute “ask anything” session or a complimentary consultation with one of our CFP® Professionals. We can meet with you in person, virtually, or by phone depending on what works best for you.
Transferring Wealth: IRAs Are a Bad Option | Watch Guide
Resources Mentioned in this Episode
- Starting the Retirement Planning Process
- Retirement Savings by Age
- Understanding Your Tax Allocation
- The Guided Retirement System
- What Is a Monte Carlo Simulation?
- How Much Do I Need to Retire?
- 2023 Retirement Plan Contribution Limits
- 6 Reasons Roth Conversions Could Work for You
- Inherited IRA Rules and the SECURE Act
- New Retirement Rules Passed by Congress
- 5 Types of Financial Plans
- What Is Financial Planning?
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Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.
The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.