When planning for retirement, most of us focus on building a nest egg that will support us in our golden years. We diligently contribute to our 401(k)s, IRAs, and other retirement accounts, hoping to maximize our savings and minimize our tax burden. However, the passage of the SECURE Act and SECURE Act 2.0 have introduced new rules that could significantly affect how your retirement savings are passed on to your heirs—and not necessarily in a good way.
The SECURE Act, which stands for “Setting Every Community Up for Retirement Enhancement,” was passed into law in 2019 and revised in 2022 with the SECURE Act 2.0. Its goal was to improve retirement security for Americans. While it includes several beneficial provisions, such as raising the age for required minimum distributions (RMDs) from 70½ to 72, and now 73, it also contains a key change that could have serious tax implications for your beneficiaries.
The 10-year rule: a hidden estate tax?
Under the SECURE Act, non-spouse beneficiaries who inherit retirement accounts, such as 401(k)s or IRAs, are now required to withdraw the entire balance within ten years. This is a significant departure from the previous rule, which allowed beneficiaries to “stretch” distributions over their own lifetimes, thereby spreading the tax burden over many years.
Let’s consider a hypothetical scenario to illustrate the potential impact of this change:
Imagine you’re a retired physician who passes away at age 80, having managed your retirement savings well. You’ve preserved a substantial portion of your IRA, which now holds $1 million. Upon your death, the account is transferred to your only child, also a successful physician, who is 50 years old and likely in their peak earning years.
Under the new 10-year rule, your child is required to withdraw the entire $1 million from the inherited account within a decade. This means that, in addition to their regular income, they will now have to report an extra $100,000 (or more, depending on how the withdrawals are structured) in taxable income each year for ten years. This could easily push them into a higher tax bracket, increasing their effective tax rate and diminishing the after-tax value of the inheritance.
The tax impact on your heirs
The result of this change is that a significant portion of the tax savings you enjoyed during your lifetime could be eroded by the taxes your child will now have to pay. The additional income from the inherited account could trigger higher tax rates, reduce eligibility for certain tax credits, and even impact the cost of Medicare premiums if your child is close to retirement age themselves.
In effect, the SECURE Act introduces what could be considered a “hidden estate tax.” While it doesn’t explicitly tax the estate, it accelerates the taxation of inherited retirement accounts, potentially leading to a much larger tax bill for your heirs than you might have anticipated.
What can you do?
To mitigate the impact of the SECURE Act and SECURE Act 2.0 on your heirs, consider revisiting your estate plan with a fiduciary wealth advisor. Some strategies that may help reduce the tax burden include:
Roth conversions. Converting some or all your traditional retirement accounts to Roth accounts during your lifetime can be a tax-efficient strategy. Roth distributions are generally tax-free for beneficiaries, provided the account has been open for at least five years.
Oil and gas investments. Investing in oil and gas can offer significant tax advantages that may offset the tax burden on your heirs. These investments often come with substantial deductions, including intangible drilling costs (IDCs) and depletion allowances, which can reduce taxable income. By incorporating oil and gas investments into your portfolio, you may be able to lower your overall tax liability, preserving more wealth for your heirs.
Strategic withdrawals. Taking larger withdrawals during your lifetime, especially in years when your taxable income is lower, can reduce the balance of your retirement accounts and, consequently, the amount your heirs will need to withdraw within the 10-year period. These times could include a large investment in a business.
Charitable contributions. If you have charitable inclinations, consider using your retirement accounts for charitable contributions. Qualified charitable distributions (QCDs) allow you to donate up to $100,000 per year directly from your IRA to a qualified charity, reducing your taxable income.
Insurance solutions. Life insurance can also be used to offset the tax burden on your heirs. By using retirement funds to pay premiums on a life insurance policy, you can provide a tax-free death benefit to your beneficiaries.
Conclusion
The SECURE Act and SECURE Act 2.0 have fundamentally changed the landscape of retirement and estate planning. While they provide some benefits, they also introduce new challenges, particularly when it comes to transferring wealth to your heirs. By understanding the implications of the 10-year rule and taking proactive steps to mitigate its impact, you can help ensure that your hard-earned savings are passed on to your loved ones as efficiently as possible.
Freddie Rappina is a financial advisor, a chartered financial consultant, and an accredited investment fiduciary who founded Opta Financial. He helps clients examine their current financial situation and financial goals, conducts a financial analysis, provides recommendations, and implements and reviews plans for his clients.
