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Reducing Taxes in Your Legacy Planning

Reducing Taxes in Your Legacy Planning

July 14, 2022

The Setting Every Community Up for Retirement Enhancement (SECURE) Act made several changes to long-standing retirement account rules. One notable change is the required timing of distributions for most non-spouse beneficiaries. Before the SECURE Act, a non-spouse beneficiary — typically a child or grandchild — could extend required distributions over their own lifetime. This was commonly referred to as the stretch provision. The stretch provision allowed families to transfer a retirement account from generation to generation.

How does it work?

Investors use after-tax distributions solely from the retirement account or in combination with other assets to purchase life insurance, with the account owner as the insured (and spouse if a survivorship policy). The beneficiary also receives the full value of the policy death benefit income tax-free, which can help offset the income taxes due on the retirement plan distributions. 

The distribution rules now require most non-spouse beneficiaries to withdraw the total retirement account value within 10 years of the account owner’s death1. The new rule likely requires a much shorter time frame for distributions than the prior rules, leaving non-spouse beneficiaries with potentially higher income taxes due, and resulting in a lower net asset value.

Qualified plans or retirement plan assets are not taxable until distributed; therefore, the stretch provision preserved the tax-deferred status of an inherited account for non-spouse beneficiaries. The stretch provision generally yielded lower required distributions and a lower annual tax liability associated with those distributions.

The funds remaining in the IRA would continue receiving tax-deferral and potential growth for decades. The elimination of the stretch provision has created more reason to consider additional planning, especially with the transfer of retirement assets under the new rules.

Since all distributions from retirement plans are subject to income tax, assets not consumed during one’s lifetime can be among the most heavily taxed assets. One way to take advantage of current lower tax rates may be for investors to take distributions now from their retirement plan.

Investors can provide financial protection for their loved ones by using those distributions to purchase life insurance. This strategy may also allow investors to maximize assets to their heirs since life insurance death benefit proceeds are generally income tax-free. Accordingly, the death benefit proceeds may help investors’ heirs offset the potential higher taxes created by the new distribution rules outlined in the SECURE Act. Individuals of any age can use this strategy to help reduce the tax burden on their heirs who will inherit retirement assets.

1Exceptions to the 10-year rule: certain non-spouse beneficiaries can take advantage of the pre-SECURE “stretch” opportunity, including minor children of the owner (until the child reaches the age of majority), a disabled or chronically ill beneficiary, an individual beneficiary who is not more than 10 years younger than the owner, and certain trusts.