Avoiding the Tax Double Whammy
Two significant factors, one currently active and another on the horizon, are poised to dramatically reduce the assets left to IRA beneficiaries. This looming “one-two punch” can be mitigated with a straightforward planning strategy aimed at protecting IRA assets from excessive taxation.
Understanding the Issue
Retirement accounts hold a vast amount of wealth, yet many are unaware of how these assets will be significantly diminished as they are transferred to the next generation. The SECURE Act of 2019 eliminated the ability for most IRA beneficiaries to “stretch” distributions over their lifetime. Now, inherited IRAs must be fully distributed within a ten-year period, leading to substantial tax implications.
The second factor is the impending sunset of the Tax Cuts and Jobs Act (TCJA) at the end of 2025. While discussions often focus on estate tax changes, for IRA beneficiaries, the potential increase in income tax rates is crucial. As beneficiaries are compelled to take large, taxable distributions from their inherited IRAs, these distributions will likely be taxed at higher rates post-TCJA.
Implications for Current and Future Beneficiaries
For those already in the ten-year distribution phase, the potential increase in marginal tax rates due to the TCJA sunset, illustrated in Table 1, suggests an increase of 0% to 4% for joint filers as rates revert to 2017 levels. Depending on individual income tax planning, it may be advantageous to accelerate IRA distributions before the TCJA sunset to avoid higher rates.
For those anticipating an IRA inheritance, accelerating distributions might push them into higher tax brackets due to the short timeline. Effective planning must occur before the inheritance is received.
Strategic Planning with Life Insurance
A noteworthy statistic is that approximately 36% of retirees who withdrew funds from a traditional IRA in 2021 used the money for reinvestment or saving, often due to Required Minimum Distributions (RMDs). For beneficiaries or IRA owners looking to protect their wealth from taxation, a life insurance policy presents an effective strategy for several reasons:
- Leverage: Each premium dollar is leveraged, increasing the amount passed to the next generation.
- Tax Benefits: Life insurance proceeds are income tax-free and have no distribution rules.
- Estate Planning: With proper planning, life insurance proceeds can also pass estate tax-free.
Conclusion
Transforming tax-inefficient IRA assets into a tax-efficient life insurance strategy can help avoid the tax double whammy created by the SECURE Act and the TCJA sunset. This approach is more relevant than ever, given current laws and Congress’s apparent difficulty in passing new legislation.
For further reading on Required Minimum Distributions (RMDs) and retirement planning, visit this article.
FAQ
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The SECURE Act of 2019 is a law that made significant changes to retirement account rules. One major change is that it requires most IRA beneficiaries to distribute inherited IRAs within ten years, rather than stretching distributions over their lifetime.
If you have more questions or need personalized advice, consulting with a financial advisor is recommended.