IRS headquarters in Washington. (Photo: Bloomberg) IRS headquarters in Washington. (Photo: Bloomberg)

Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.

Many Americans have started to adjust to changes brought on by the sweeping tax overhaul enacted in 2017. However, new changes introduced by the recent Setting Every Community Up for Retirement Enhancement Act, or Secure Act, could have a big impact as well. Advisors who specialize in retirement income planning, particularly for the mass affluent, should be aware that some of these changes could cause eventual tax headaches, particularly those related to the new, later age for required minimum distributions, and the elimination of the “stretch IRA.”

Increasing the RMD age to 72 may seem on face to reduce the tax burden as withdrawals from IRA accounts could be deferred an extra year or two over the old rules, depending on the client’s birthday. For clients whose IRAs are over-funded, the change may actually increase the lifetime tax bill.

An additional year or two years of deferral will allow the balances in these accounts to continue to increase, which causes the RMD at age 72 to be larger than it would have been at 70 ½. If the client is able to meet their desired lifestyle need with less than the full RMD, then any excess RMD will be taxed at the client’s highest marginal rate, which may be higher than if the client were to spread withdrawals over a longer period of time.

Since most well-funded clients in the absence of advice generally delay IRA withdrawals for as long as possible, the default will likely be a shorter distribution period coupled with a larger account balance, resulting in more income being taxed at the client’s highest marginal rate, albeit for a shorter period of time. If the client’s beneficiary is in a lower tax bracket, those changes could work out to be a positive, but a second change, the creation of a 10-year distribution period for IRAs, makes that much less likely.

Prior to the Secure act, IRA distributions from inherited accounts could be spread over the beneficiary’s lifetime, often referred to as a “stretch IRA.” The tax benefits of a stretch could be substantial, as only a small portion of the IRA was required to be distributed each year, allowing additional compounding and the ability to minimize withdrawals during the beneficiaries’ highest earnings years. The 10-year provision has both positives and negatives. The positive is that it actually creates more flexibility within the first 10 years after the client’s death, but the negative is that flexibility is only available for 10 years.

For example, under the old rules, a 62-year-old high wage earner who planned to retire at 65 and inherits an IRA from his deceased mother would need to take distributions from the inherited IRA right away, despite the fact that he doesn’t need them to meet his cash-flow goals. These distributions would have been taxed at his highest marginal rate. Under the Secure act, he could take no withdrawals for the first three years, then heavy withdrawals between 65 and 72, at which point his own required minimum distributions would kick in. Planning opportunities will abound for people who need to coordinate the usage of their inherited IRAs with their own IRAs.

On the other hand, a younger beneficiary may not be able to retire within 10 years, which means that withdrawals should be spread out strategically to take advantage of lower earning years, or could be coordinated with an increase in 401(k) contributions to offset the higher income coming into the household and effectively “reset” the clock on those funds to the beneficiary’s RMD age. Determining which situation better describes your client requires a financial plan projecting income needs now and in the future, as well as RMDs for both the inherited IRA and the beneficiary’s IRAs.

Another complication is related to trusts established to control IRA distributions. In the past, advisors have used trusts to help clients control funds after their death. However, the Secure Act has disrupted trust planning. Some trusts were written to say that a client’s beneficiary can take only the required distribution. If that’s the case for your client, the trust needs to be modified. Otherwise you’re setting the beneficiary up for a bad tax situation. If the trust is not modified, all of the IRA money will be forced out of the IRA in the final year. This would cause the effective tax rate on these funds to be significantly higher than if distributions were spread out, filling lower brackets throughout the 10-year period.

The Hidden Value

Most CPAs and accountants who do tax returns for middle-income people want to help their clients pay as little tax now as possible. Yet often that’s not the best choice. Good planning is about understanding the tax burden you’re leaving behind and trying to find a good equilibrium between taxes now and taxes later. Start the conversation now, knowing that you probably won’t close it until later in the year. Tax season is a good time to address the topic since clients have taxes on their minds.

Good tax planning is about being able to visualize all the scenarios, and a visual tool can help you show the client the things they didn’t see originally. By showing clients areas where you can add money to their retirement, you can deepen their trust in you, secure their commitment and even lead them to tell their friends and family about you.

Check out our webinar, Understanding the SECURE Act – What Your Clients Need to Know, at 2 p.m. on Feb. 13.

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Joe Elsasser, CFP, Covisum

Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn’t find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.

In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly impact cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model “what-if” scenarios with account positions and align a client’s risk tolerance with their portfolio risk.