Florida Bar Journal

Individual Retirement Accounts: What a Long, Strange Trip It’s Been

In the November/December 2019 issue of The Florida Bar Journal, I outlined individual retirement arrangement/account (IRA) basics and warned readers of the possibility of new legislation then gaining favor in Congress that would end the life expectancy payout permitting beneficiaries inheriting IRAs to stretch out “required minimum distributions” (RMDs) over the beneficiary’s lifetime (stretch IRA).^[1] I did not think at that time that the proposed legislation would pass in 2019, but, surprisingly, the Setting Every Community Up for Retirement Enhancement Act or SECURE Act (SECURE 1) was signed into law December 20, 2019, giving advisors little time to prepare clients for and adjust advice related to this radical legislation.^[2] Since that time, tax advisors have been on a roller coaster ride from (mis)interpreting SECURE 1, which one could easily argue made retirement savings less secure, and the subsequent changes made to that legislation — until September 2024, when the final Treasury Regulations relating to the SECURE Act and its progeny became effective.

As of September 30, 2024, U.S. retirement assets, the majority of which are held in pre-tax accounts, including IRAs and 401(k) plans, were $42.4 trillion and accounted for approximately 33% of all household financial assets.^[3] For decades, families based their financial planning strategies around these retirement plans and the then applicable law. In 2019, faced with then mounting national debt exceeding $23 trillion, Congress, focused on revenue generation, turned its attention to pre-tax traditional retirement accounts by implementing the SECURE Act and essentially killing the stretch IRA for all but a few special classes of individuals. Now, the deficit is over $36 trillion. Income tax rates in recent years have been among the lowest they’ve been since the 1980s, but given the country’s massive debt, this is likely not sustainable. Even if the current administration extends the Tax Cuts and Jobs Act’s lowered individual tax brackets for a number of years;^[4] income tax rates will likely have to increase in the future, providing a tremendous opportunity now for some great tax planning to protect assets clients have spent a lifetime accumulating.

This article discusses 1) some basics of the SECURE Act and its amendments, and 2) tax planning ideas for IRAs to assist you in structuring strategies to help clients protect these accounts, including 1) multiple beneficiary charitable remainder trusts as IRA beneficiaries and 2) converting traditional IRAs to Roth IRAs. The focus will surround IRAs because they are the most common retirement arrangements and many of the tax rules governing IRAs are similar to those of other types of retirement accounts. However, caution must be taken if you’re advising clients with respect to 401(k), 403(b), 457, or other retirement plans because there are some key differences among the various arrangements.

SECURE 1

SECURE 1 made significant changes to retirement benefits, including: 1) increasing the age at which RMDs must start from 70 ½ to 72 years of age (the applicable age or RMD starting age); 2) permitting contributions to IRA accounts after 70 ½ years of age; and, most significantly, 3) radically modifying the IRA distribution rules for account owners dying after 2019 by essentially destroying the stretch IRA for their “designated beneficiaries” (DBs) by mandating that distributions to DBs must be made within 10 years after the IRA owner’s death (10-year rule),^[5] unless the DB qualifies under SECURE 1’s newly created subgroup of five special classes of “eligible designated beneficiaries” (EDBs). The special categories of EDBs (not discussed here) entitled to continue taking the stretch IRA include spouses of the IRA account owner, disabled or chronically ill individuals, those who are not more than 10 years younger than the account owner, or children of the account owner who have not reached “the age of majority,” which was not originally defined.^[6] After an EDB dies or ceases to qualify as an EDB, the 10-year rule becomes applicable, regardless of the characterization of the next/final beneficiary of the account.

Not surprisingly, there were many unresolved questions arising from the initial legislation, probably the most significant of which was whether any distributions had to be made to IRA beneficiaries during the 10-year period. Tax planners believed, and IRS Publication 590-B originally illustrated, DBs had no obligation to take distributions from IRAs until the end of the 10-year period. Sighs of relief ensued as advisors believed they had a 10-year runway to plan for distributions of account proceeds…until February 2022, when the IRS issued proposed Treasury Regulations under §401(a)(9) of the Internal Revenue Code of 1986, as amended (the code) which included the shocking provision that if a traditional IRA owner had begun taking RMDs out of their account prior to death, the beneficiary must also take out RMDs and cannot wait until the 10th year to take the entire distribution from the account.^[7] Chaos ensued as those who appeared to have been required to take RMDs but didn’t, were facing a 50% excise tax or penalty on the missed RMD amounts.^[8]

SECURE 2.0

Modifications building from SECURE 1 and the associated proposed regulations promulgated thereunder resulted in the enactment of the SECURE 2.0 Act (SECURE 2), which was signed into law December 29, 2022.^[9] Some provisions of SECURE 2 became effective in 2023, while others had or have staggered effective dates.

Building upon SECURE 1 raising the RMD Starting Age from 70 ½ to 72, §107 of SECURE 2 further modified this age for those born on or after January 1, 1951, but assigned RMD starting ages of 73 and 75 for those born in 1959, providing confusion.

SECURE 2 reduced the penalty individuals pay if they fail to take their RMD in a particular year from 50% to 25% of the shortage. If a taxpayer corrects their failure to take their RMD within two years, the penalty may be further reduced to 10%. These are welcome changes since the RMD rules confuse most clients and a considerable number of advisors.

Also welcome were SECURE 2’s numerous exceptions to the 10% penalty associated with early withdrawals (i.e., account owner withdrawals made before attaining 59 ½ years of age), each with differing effective dates and limits.^[10] One such exception is for victims of federally declared disaster areas. Effective January 26, 2021, account holders in these disaster areas can withdraw up to $22,000 penalty free and have up to three years to repay the amount withdrawn to avoid penalties. This relief could be extremely useful to our clients affected by hurricanes and/or flooding.

In addition to amending §401 of the code, SECURE 2 made positive changes to code §529, permitting beneficiaries of 529 college savings accounts to roll over up to $35,000 from their 529 account to a Roth IRA. These rollovers are applicable to 529s that have been in existence for more than 15 years and are still subject to the Roth IRA contribution limits.^[11]

Neither SECURE 1 nor SECURE 2 modified the threshold age of 70 ½ for making qualified charitable distributions (QCDs), permitting owners to make a direct transfer from their IRA accounts to charity (excluding donor advised funds) of up to $100,000, thereby giving IRA owners the benefit of excluding such transferred funds from their gross income. However, under SECURE 2 as of 2024, the $100,000 limit is now adjusted for inflation. In addition, SECURE 2 now permits owners to make a one-time $50,000 QCD transfer to a “split interest entity,” including qualifying charitable gift annuities or split interest trusts or “charitable remainder trusts,” subject to several limitations, including that the beneficiaries of such charitable remainder trusts can only consist of the account owner and their spouse.^[12] Given the cost of creating and maintaining a charitable remainder trust and the limitations surrounding these arrangements, this isn’t the most attractive choice; perhaps the charitable gift annuity is more appealing.

SECURE Act — Final Regulations Regarding Required Minimum Distribution Rules

In July 2024, the Treasury issued final regulations under §401(a)(9) of the code which became effective September 17, 2024. These regulations essentially follow the proposed regulations but include much needed clarification. For example, the regulations corrected SECURE 2’s error and clarified the new RMD starting age brackets in Chart 1.^[13]

The shocking change within the proposed regulations requiring RMDs from IRA accounts owned by individuals who died after their required beginning date (RBD, which is April 1 after the owner attained their RMD starting age) was retained. This means that if an IRA owner dies after the RBD and names a designated beneficiary, distributions (generally based on the life expectancy of the beneficiary) must continue to be made during the 10-year period and the balance of the account must be distributed by December 31 of the 10th year after the year of death.^[14] If the owner dies before the RBD and has named a designated beneficiary, no annual distributions are required to be made, but the account must be distributed by the end of the 10-year period.^[15] This mandatory RMD rule for certain beneficiaries applies to distributions beginning in 2025. IRS Notices made clear that the beneficiary who failed to take the annual distributions in 2021-2024 will not be liable for an excise tax.^[16] Significantly, for purposes of the RMD rules, Roth account owners are always deemed to have died prior to their RBD (even if they died after their RBD) and, thus, no annual payments are required during the 10-year period.^[17]

Charitable Remainder Trusts as IRA Beneficiaries

The glut of untaxed retirement accounts and the destruction of the stretch IRA for all but the elite eligible designated beneficiaries necessitates pivoting to alternate retirement planning for families. The 10-year rule will force most designated beneficiaries to take taxable distributions from these accounts when they are in their highest income tax brackets and will distribute large sums outright to addicted/affected beneficiaries without additional planning. To assist taxpayers to extend the period during which the IRA grows in value and permit distributions to beneficiaries over a longer period, a multiple beneficiary charitable remainder trust (CRT) can be named as traditional IRA beneficiary and achieve stretch IRA type results.^[18] This sophisticated tax planning strategy offers significant advantages to families, including: 1) providing a gradual transfer of greater wealth over the beneficiaries’ lifetimes not attainable under the 10-year rule; 2) family control; and 3) asset protection.^[19]

A CRT is an irrevocable tax-exempt trust that distributes a percentage of trust assets in the form of an annuity to one or more individual beneficiaries for life or for a term of up to 20 years. After the term ends, the trust is wound down and the remaining trust assets are distributed to a designated charity. Section 664 of the code requires the percentage of trust assets to be distributed to the individual beneficiaries to fall within 5% to 50% of the CRT’s value. These payments can be fixed based on the initial trust value (this is commonly referred to as a “charitable remainder annuity trust” or CRAT) or may be based upon the value of the trust assets each year (a charitable remainder unitrust or CRUT). The actuarial value of the charitable organization(s)’s remainder interest must equal at least 10% of the trust’s initial fair market value. Transfers to CRUTs qualify for income, gift, and estate tax charitable deductions, making them extremely attractive to clients with taxable estates. While the CRT holds the traditional IRA funds, the full value of those funds will be held without reductions for income tax and will generate income for distribution to the individual beneficiaries, making CRTs more advantageous over other irrevocable trusts holding IRA funds after the account owner’s death.

While most CRTs are designed with one or two individual beneficiaries, it is possible to name more than two beneficiaries (e.g., three children) and achieve stretch IRA type results by designating the CRT as the IRA beneficiary. CRUTs are often preferred in this context because their payments are adjusted each year based upon the value of the trust assets which allows payouts to increase as the CRUT’s assets grow in value, thereby providing greater wealth transfer. In contrast, CRATs provide annuity distributions based upon the initial value of the trust only, and, as a result, CRATs generally provide more funds to charitable organizations and are less attractive. Adding flexibility, CRUTs can by drafted as: 1) “charitable remainder net-income unitrusts” (NICRUTs), which pay the lesser of a year’s net income or a fixed percentage (5% to 50%) of the annual trust value; 2) “charitable remainder net-income with make-up unitrusts” (NIMCRUTs), whereby the trust pays in excess of the stated annuity payout percentage to make up any shortfall from previous years when the net income limit caused the individual beneficiaries to receive less than the stated payout; 3) or as “flip unitrusts” (FLIPCRUTs), which are CRUTs that begin as NICRUTS or NIMCRUTs, but convert to standard CRUTs the year after a specified date or stated event. These special trusts are excellent for retirement accounts holding illiquid assets that do not produce the annual annuity.

Generally, CRTs can provide a percentage of trust assets for beneficiaries either jointly or successively. In trusts providing for beneficiaries jointly, multiple beneficiaries receive income simultaneously. For example, two or more children could share annual payouts for as long as the trust remains in effect. Alternatively, successive arrangements allow one beneficiary to receive income first, such as a surviving spouse, followed by additional beneficiaries, such as children, after the initial beneficiary’s term concludes. Successive beneficiaries can extend the trust’s term significantly, depending on the ages and lifespans of the beneficiaries.

Of course, the addition of multiple beneficiaries impacts the charitable remainder. Higher payouts to beneficiaries reduce the remainder, potentially jeopardizing the CRT’s compliance with the 10% charitable remainder requirement. Further, the ages of the beneficiaries strongly impacts the success of this arrangement. If the IRA owner’s children are too young to achieve a lifetime payout, a 20-year term payout at a higher (optimized) percentage may achieve satisfactory results.

The positive aspects of using a CRT as IRA beneficiary must be balanced against the drawbacks, which include: 1) the costs and complexities of administering the CRT; 2) CRTs are irrevocable so changes cannot be made to the trust terms; and 3) the annuity payments must be made outright to each individual beneficiary, thereby exposing them to each beneficiary’s creditors.

The results of the CRT approach depend on the ages and number of beneficiaries, the interest rate under §7520 of the code, and the payout rate selected, but it is certainly possible for the beneficiaries to receive as much if not more than the stretch IRA would provide, making this an extremely beneficial technique — again, particularly for those with taxable estates.

Converting Traditional IRAs to Roth IRAs

Even if unphased by the drawbacks of the multi-beneficiary CRT as IRA beneficiary, many clients cannot overcome the concept of a portion of their retirement accounts going to charity instead of being distributed entirely to family members. These clients may want to consider converting traditional IRAs to Roth IRAs now while the tax rates are among the lowest they’ve been in over 30 years.

Traditional IRAs and Roth IRAs follow contrasting tax principles since, unlike traditional IRAs which typically hold pre-tax dollars, Roth IRAs hold post-tax dollars, meaning contributions are made with after-tax money, and growth and withdrawals in retirement are tax-free. For many individuals, tax-free compounding is the most efficient tax planning option possible. Unlike traditional IRAs, Roth IRAs do not have RMDs — even for beneficiaries (though the 10-year rule applies) — so owners and family members can enjoy the significant tax-free growth well beyond the owner’s attaining age of 73, or 75 for those born in 1960 and thereafter. Roth accounts can possibly net more money to families in the long run since they receive tax-free compounding and the withdrawals of earnings are tax-free for both the account owner and his or her beneficiaries. This can be particularly true if income tax rates increase. For example, if a 60-year-old male has a $5 million traditional IRA and he and his 35-year-old son are in the 37% bracket when the father converts the IRA to a Roth account January 1, 2025, the net tax benefit to the family would exceed $500,000 if tax rates increased to 39.6% on January 1, 2026 (per the current legislation), assuming a constant rate of growth. Finally, there are additional benefits of Roth IRAs over traditional IRAs where the owner has an estate subject to the federal estate tax.^[20]

The tradeoff in converting a traditional IRA to a Roth IRA is that when you convert, you will owe income taxes in the year you make the conversion on any money in the traditional IRA that would have been taxed when you withdrew it, i.e., the tax-deductible contributions you made to the account as well as the tax-deferred earnings that have built up in the account. If the focus is on the overall effect, not the upfront income tax hit, Roth conversions can potentially produce tremendous results.

Currently, there are basically no limits on the number and size of Roth IRA conversions individuals can make from traditional IRAs per year. However, this approach may not be advisable in some cases because it could push the individual into a higher income tax bracket than necessary, resulting in increased tax liability. It is, therefore, often best to execute the conversion over several years if the taxpayer is not in the top marginal bracket, and, if possible, convert more in years when their income is lower or the market is down significantly. If the current lower income tax brackets are extended beyond 2025, the smart play may be to convert annually before the tax rates increase. Stretching transfers out may also reduce the risk of high taxable income causing lost tax deductions, credits, or other benefits tied to adjusted gross income. Added income may also increase Medicare premiums in some cases. In terms of timing, individuals may want to convert in the early part of the year, giving them as much time as possible to pay the added tax due (e.g., if one converts to a Roth IRA January 2, 2025, the tax isn’t due until April 15, 2026).

Unlike naming a CRUT as IRA beneficiary, naming individuals as beneficiaries of Roth or traditional IRAs may not offer any creditor protection and these accounts will be included in the beneficiaries’ estates — which is not an optimum result, particularly for children living in states implementing a state estate or inheritance tax.

Conclusion

The SECURE Act and its progeny significantly altered retirement plan and IRA beneficiaries’ ability to have lifetime payouts from these arrangements by generally requiring plan interests to be distributed by the end of the 10th year following the death of the account owner. To delay the taxation of the distribution of these accounts, gain additional creditor protection, and attain an estate tax deduction, taxpayers may desire to implement a charitable remainder trust permitting distributions over the lifetimes of multiple beneficiaries. If they otherwise desire to achieve a better tax result based on tax-free growth, they may desire Roth IRA conversions. Given the glut of pre-tax retirement funds that will be pushed out in a 10-year time frame and the threat of income tax hikes in the future, this is a unique prime opportunity to provide invaluable tax advice to clients by reviewing and updating their retirement planning.

This column is submitted on behalf of the Tax Law Section, Mark Scott, chair, and Charlotte A. Erdmann, editor.