Over the years, tax law has undergone several changes that have impacted clients’ retirement and legacy planning. The SECURE Act eliminated the “stretch IRA” provisions for anyone other than a surviving spouse. This means that beneficiaries of an inherited IRA must withdraw all funds from their inherited accounts within 10 years of receiving them. This change has eliminated their ability to “stretch” out payments, which previously allowed for a longer distribution period with tax-favorable growth.
On the other hand, the Tax Cuts and Jobs Act offered us favorable tax advantages, such as reduced income taxes, a higher standard deduction and increased limits on federal estate and gift taxes. However, these changes are reverting to prior levels on January 1, 2026.
What’s the Problem?
The impact on clients is that any qualified income will now be taxed at a higher rate, whether that is received by you or your heirs. Additionally, the rate of distribution has been limited from a lifetime to ten years, creating the potential for higher taxation during your retirement years or your heirs’ highest income-earning years.
There are three issues to consider:
- If you take qualified distributions, they will be taxed at a higher income tax rate. This impact may be compounded by RMDs (required minimum distributions).
- Any inherited qualified money will need to be distributed by the end of the 10-year period after receiving it, potentially increasing the beneficiary’s tax liability and reducing the overall size of the gift.
- If you need to use your qualified money to pay for long-term care, the increase in distributions will raise your adjusted gross income, inadvertently increasing your 7.5% threshold for deducting qualified medical expenses.
How Can You Plan More Efficiently?
One way to mitigate your tax risk is by repositioning your qualified money into alternative wealth transfer vehicles. One method is to utilize a qualified charitable distribution, which would allow you to directly gift a portion of your qualified money to a qualified charity while taking a deduction for those gifts in that year.
While the qualified charitable deduction may be a strategy for some, if you find yourself in a “what if” position — such as wondering if you’ll need those funds for retirement, if you might want to change your gifting plan or if you’ll need those funds for long-term care — you may need a more flexible planning option. That option might involve utilizing another alternative wealth transfer vehicle, such as a life insurance policy. While one would still have to recognize ordinary income tax on the distributions from the qualified plan to pay the premium of the life insurance policy, the life insurance policy offers the following advantages:
- The death benefit is income tax-free.
- The policy can be purchased inside an irrevocable trust for federal estate tax planning.
- The policy can be used to pay for long-term care; by accessing the death benefit to pay for care.
- The policy grows cash value on a tax-favorable basis. If your needs change, you have an exit strategy.
Depending on your overall goals, life insurance can be a valuable tool in helping to alleviate tax risk. It aids in transferring assets efficiently to the next generation, avoiding income taxation or federal estate/gift taxation and protecting against the costs of long-term care.