New changes that will limit how far certain beneficiaries can stretch an inherited IRA have the retirement management community concerned. This is not a big change though.
Retirement advisors are scrambling to find ways that their clients can work around the new rule changes that will be implemented in the upcoming Secure Act that restricts stretching out IRAs that are bequeathed. There are also a lot of people upset about this new rule change, although at least some of the complaints aren’t really valid and others aren’t so unreasonable if we consider the purpose of IRAs and other retirement accounts.
Under current rules, you can bequeath your IRA to any beneficiary, and they are not under any time limitation to deplete the account. The current rules will continue to apply to spouses, as well as minor children and those who are disabled. Everyone else will soon be subject to a 10-year limitation on keeping the account open, which is what so many people are up in arms about now.
The first qualm that we hear is that retirees have saved all this money over all these years with the expectation that they will be able to leave their IRAs to their loved ones and this new rule changes all that. The problem though is that it really doesn’t, because we need to ask ourselves what alternatives we would have pursued had we known this years ago, and this isn’t something that they are thinking about.
If we want our kids to inherit this tax advantaged money, we cannot do so with non-retirement accounts, where they would not receive any tax benefits from the retirement plan at least, where now they are only getting 10 years’ worth of these benefits. There’s no reason why they would not have chosen the 10 years of tax relief over none, in addition to losing out the tax benefits with this money themselves.
Having advanced warning of this really would not have changed things. This isn’t stopping people trying to make this argument though, like Ed Slott, the founder of IRAHelp.com, who calls this a “broken promise.” There were no promises made though, and all legislation is subject to revision or repeal, and if the promise is not made but assumed, we only have ourselves to blame if circumstances change and we have relied on our imagined promises too much. This isn’t even a practical concern with this though.
Even if Congress did away with retirement plans altogether, this would not have a material effect on people’s savings from the perspective of the past, other than having them wrongly discouraged from doing the right thing and taking advantage of these tax benefits for the time they did exist. A tax break for years that ends up being discontinued is still a clear benefit that we should wish to take advantage of regardless.
If we wanted to complain about broken promises, the upcoming turmoil with Social Security would be a much better thing to focus on, but the U.S. government makes no promises, and in the end, we have no choice but to accept the circumstances and do our best to adapt. The money we contributed to Social Security could have been invested much more wisely than just using it to buy treasuries, but it was not, and we are then faced with either accepting the reality of this or not, as there is no potential redress.
This New Rule Actually Makes a Lot of Sense
It’s actually hard to argue against what this legislation is trying to do with this limitation, which is to have IRA accounts do what they were intended, to allow people to save more for retirement and not to provide a took to reduce taxes with estate planning. Allowing the tax advantages of an IRA to be passed on to your surviving spouse is one thing, but looking to do this for your kids is quite another, because this has nothing to do with your retirement and retirement accounts focus on that.
We typically allow benefits to flow through to surviving spouses, as we treat couples as a single entity in some cases and the surviving spouse very often relies on this retirement income to live on. In most cases, the surviving spouse won’t be around either in 10 years, but if they are, we are willing to give them as much time as they need as long as they make the required withdrawals.
The reason why we have required withdrawals with retirement accounts is that this money is supposed to be saved up to be spent in retirement, and this is one of the reasons why we have contribution limits, to limit this tax sheltered nest egg to reasonable amounts that may be needed to live on, not to shelter larger amounts of wealth from the tax man for the benefit of others.
The fact that the U.S. allows the transfer of tax benefits to non-spouses is in itself strangely overbroad, and even the 10-year period that this is being reduced to is 10 years beyond what it would make sense to provide under the objectives of these retirement plans, which is to provide for retirees and their spouses and not to provide for other members of their family such as their adult children.
We could even say that ever enjoying such an advantage would be an abuse of the system and its intent, which is not to lower the tax obligations of people’s descendants or anyone else other than the couple in retirement. These plans also serve to provide an incentive for people to save for their retirement, not to provide one to build the value of their estates up beyond their own needs so that they will have more to leave their children.
If people want to lobby for more tax friendly estate planning, that’s the road they should be taking, not complaining about rules designed to bring retirement savings truer to their purpose and to also try to limit people using them for other purposes. While no one enjoys paying more tax, and even will object to their kids paying more, we should not expect special tax considerations to help us enjoy retirement to be something we could just transfer to non-retirees this way.
Those who are unhappy with this are truly lucky that they didn’t do away with passing these tax savings on to non-spouses at all, but perhaps Congress did not wish to upset people too much and came to the 10-year rule as a matter of compromise. In any case, this legislation is expected to pass without any issue and we’ll just have to deal with it the best we can.
This only really affects the wealthy, as most people have a difficult enough time to make their retirements savings last their own lifetimes, and in fact the great majority of people have not saved enough to even take care of themselves properly. Folks that have both a significant amount of non-sheltered assets in addition to tax sheltered ones are the ones that will be upset here, and therefore will have higher incomes and be in higher tax brackets than the average retiree.
Our Workarounds Need to Actually Work
We need to keep this in mind when we examine some of the workarounds that are being suggested by retirement planners, such as converting these traditional IRAs into a Roth IRA. It is hard to imagine that someone would end up seeing less tax paid on declaring the whole amount in a given year and paying the tax now versus passing this off to their kids whose incomes may both be more modest and can also enjoy the benefits of this tax deferral for 10 years.
Roth IRA rollovers can make plenty of sense for those whose incomes are on the lower side and whose account sizes are also modest, but doing this with higher income folks with large accounts will result in people a lot more tax, which surely cannot be a goal of a tax reduction strategy.
The second suggested workaround is to donate money to charity, and while that can reduce the tax burden, it is certainly not a solution if we want our descendants to enjoy more of our money, as this will result in their getting a whole lot less, even though the charities will be happy enough. If one is disposed to donate anyway, the tax write-off can be a bonus, but this is not a good strategy if you’re just doing it for tax purposes and especially if you want to use it to increase the value of your estate, which is ridiculous.
The third workaround instructs us to bequeath non-sheltered assets instead of sheltered ones, which does not make much sense either. People will presumably bequeath both, the entirety of their estates, and while there may be considerations as to whether retirees should spend down their IRAs more for tax purposes in favor of ordinary assets, once again, it’s hard to imagine how people who have such wealth that they are losing sleep over this to be the ones that we want to see paying the taxes on this money and somehow end up ahead.
Elderly folks don’t know how much time they have left, and even if they pay a lower marginal tax than their children, which in these situations probably isn’t the case, they can’t be too patient with such a strategy. Even if they have the same 10 years as their kids do, they can’t know this and would therefore be disposed to do this all sooner rather than later, pulling out larger amounts per year than their kids would have to.
There is a single idea with this one that does make a little sense though, and that’s to bequeath stock positions to their loved ones intact, where the loved ones are free to hold the stocks as long as their hearts desire, even into their own retirement if they want.
This is actually a good estate planning strategy, but we need to keep in mind that this is all about estate planning and has at least less to do with retirement savings than it used to, even though we probably should not be given a means to conflate the two like we still do under the new Secure Act.
There are other estate planning techniques that can be used to reduce estate taxes, such as taking advantage of the rules concerning gifts, but this really is another area of taxation altogether.
Some retirement experts are worried that some people may allow their confusion over this to withhold contributing to their retirement, even though it always makes sense to take the tax breaks that are offered provided that this results in an advantage for us.
The sole purpose of an IRA is to have us pay less tax while we save for our retirement, and whatever else we have in mind with the money, less tax paid means more in our pockets. It also allows us to declare it as income at a stage in our lives where our income is lower, which is the case with the great majority of retirees, and we don’t want to allow our displeasure with changes that are clearly outside the intent of these accounts to have us doing the wrong thing and paying more tax ourselves or having our descendants pay more tax when it’s preferable not to.
It’s not that all that many people are affected by this very much, because unless you have a whole lot to leave, and most people do not, 10 years is plenty enough time for their children to finish withdrawing from their parents’ IRAs, and in most cases, it will not take anywhere near this long as they often will need or want to spend this money sooner than that.
It can be argued pretty easily that we need to do more to help people save for retirement, given how little most people currently manage to save for it, which is a pittance compared to what they will need for themselves alone, so they don’t have to lean on their children rather than the other way around with those wealthy enough to have this kind of excess.
There will be more tax paid as a result of this change, but that’s exactly the point. We don’t like to pay taxes, but we still have to, the amount that our governments deem appropriate. Being upset just serves to reduce our enjoyment of life, and whatever price we pay is ultimately one we extract ourselves, even though it’s always easy to pass the blame whenever we desire.
This change is very much reasonable though. There’s plenty of more reasonable complaints we may want to make about modern-day taxation, especially with estate taxes, where we can claim that this money has already had tax paid on it and hitting our estates up again for a percentage of net income can reasonably be seen as excessive. The very idea of a wealth tax commits the same mistake and is far more repugnant as well.
This one isn’t though. If we wish to seek estate tax reform, we need to at least be trying to bark up the right tree, not a different one that has had its branches extendi too far and in need of trimming, as is the case with this new rule. We have no choice but to accept this change and manage the best we can, which is always the most we can do.