Kerry Pulliam
Advanced Strategies for Large IRAs: Navigating SECURE Act 2.0, Roth Conversions, and Innovative Wealth Transfer

By Kerry W. Pulliam, CFP, AEP, CEPA

Apogee Capital Resource Group

Email: Kerry.Pulliam@CapitasFinancial.com | Phone: 502-599-6623

 

Executive Summary: Optimizing Large IRAs for Multi-Generational Wealth Transfer

For high-net-worth (HNW), ultra-high-net-worth (UHNW), and private wealth clients, substantial wealth held in tax-deferred retirement accounts like IRAs presents both immense opportunities and intricate challenges, especially when it comes to intergenerational wealth transfer. While these assets offer remarkable tax-deferred growth during a client's lifetime, they can become significantly burdened by both income and estate taxes upon death, potentially eroding the legacy intended for future generations. This reality demands a proactive and sophisticated planning approach that goes far beyond traditional retirement income strategies.

 

This guide is crafted to empower financial advisors like you with advanced strategies designed to mitigate these multi-layered tax burdens and amplify legacy value. We'll delve into the nuanced impacts of SECURE Act 2.0 on inherited IRAs, explore strategic Roth conversions to proactively manage and shift future tax liability, and introduce the innovative "synthetic Roth conversion" (IRA maximization), leveraging permanent life insurance for highly tax-efficient wealth transfer. Additionally, we’ll detail the powerful concept of a "synthetic family foundation," utilizing Donor-Advised Funds (DAFs) for philanthropic impact alongside family wealth.

 

Our goal is to equip you with a comprehensive toolkit, guided by the FLIGHT diagnostic process, to help your clients achieve their multi-generational financial and philanthropic objectives with maximum tax efficiency.

The Evolving Landscape of Inherited IRAs: SECURE Act 2.0 and Beyond

 

F - Foundation of Knowledge: Understanding the 10-Year Rule

The SECURE Act of 2019, along with subsequent clarifications from SECURE Act 2.0, fundamentally reshaped the rules for inherited IRAs, particularly for non-spouse beneficiaries. For IRA owners who passed away after December 31, 2019, the popular "stretch IRA" strategy—which allowed beneficiaries to spread distributions over their own lifetime—has largely been replaced by a mandatory 10-year distribution rule. This means most non-spouse beneficiaries must now withdraw the entire inherited IRA balance by December 31 of the year marking the 10th anniversary of the original owner's death.

 

This acceleration can lead to significant income tax burdens for beneficiaries, especially if they're in their peak earning years, potentially pushing them into higher marginal tax brackets. The IRS has even acknowledged this complexity by waiving missed RMD penalties for inherited IRAs from 2020 through 2024, highlighting the critical need for your clear guidance and proactive planning.

 

The specifics of Required Minimum Distributions (RMDs) within this 10-year period vary:

  • If the original account holder had already begun taking RMDs before their death, the beneficiary must continue taking annual RMDs based on their own life expectancy, in addition to emptying the account within 10 years.
  • Conversely, if the account holder had not yet started RMDs, the beneficiary must still empty the IRA within 10 years, but annual distributions aren't required during that period; only the full balance by the 10-year deadline is mandated.

This shift transforms a long-term, tax-deferred growth vehicle into a much shorter-term, taxable income event. It's not just about paying taxes sooner; it's about potentially paying a larger total tax amount over time. Receiving a large sum over a compressed 10-year period, especially from traditional IRAs, significantly increases the likelihood of beneficiaries being pushed into higher marginal income tax brackets. This erosion of long-term compounding benefits compels advisors to prioritize pre-death tax planning for the original owner to mitigate future burdens on heirs. While there's some flexibility to strategically time withdrawals within the 10 years, the compressed timeline demands proactive solutions.

 

I - Identify Indicators and Implications: Exceptions to the 10-Year Rule

Not all beneficiaries are subject to the strict 10-year distribution rule. SECURE Act 2.0 carves out specific categories of "Eligible Designated Beneficiaries" (EDBs) who can still stretch distributions over their life expectancy. These critical exceptions include:

  • Surviving spouses of the account holder.
  • Minor children of the account holder (though this exception is temporary; the 10-year rule generally begins when they reach the age of majority, typically 21).
  • Disabled or chronically ill individuals.
  • Individuals not more than 10 years younger than the original account holder.

For EDBs, the ability to stretch distributions over their life expectancy remains a powerful tax-deferral tool. You should diligently identify these beneficiaries to preserve tax-deferred growth where possible.

 

A crucial point for minor children classified as EDBs: while they can initially take RMDs based on their life expectancy, this exception expires when they turn 21. This creates a predictable "tax cliff," where a potentially large IRA balance must be fully distributed over the subsequent 10 years, likely coinciding with a period when the young adult is entering their career and potentially facing higher marginal income tax rates. To proactively plan for this "Age 21 Cliff," consider partial Roth conversions before the original owner's death, utilizing life insurance strategies to offset the future tax burden on the child, or even structuring trusts to manage distributions beyond age 21.

 

Spouse vs. Non-Spouse Beneficiaries: Distinct RMD Rules

The type of beneficiary significantly impacts RMD rules and planning options:

  • Spouse Beneficiaries: Spouses have the most flexibility. They can roll over the inherited IRA into their own, delaying RMDs until they reach their own RMD age (currently 73, or 75 beginning in 2033). They can also keep it as an inherited IRA and take distributions based on their own life expectancy or opt for the 10-year rule.
  • Non-Spouse Beneficiaries: Most non-spouse beneficiaries are subject to the 10-year rule, with exceptions only for Eligible Designated Beneficiaries.
  • Estate, Entity, or Trust Beneficiaries: When an IRA is left to an estate, entity, or trust, the assets generally move into an inherited IRA in the entity's name. RMD rules here depend on the original owner's death date and may involve a 5-year distribution rule or RMDs based on the original owner's age. For trusts, due to their complexity, consulting a tax advisor or attorney is highly recommended.

Proactive Tax Management: Roth Conversions

 

G - Guide Client Through Process: Strategic Roth Conversions

Roth IRA conversions involve transferring funds from a traditional IRA (or other pre-tax retirement accounts) to a Roth IRA. The primary benefit: while taxes are paid on the converted amount in the year of conversion, all future qualified withdrawals from the Roth IRA, including earnings, are entirely tax-free. This offers a powerful hedge against potential future tax rate increases and provides tax-free income in retirement.

 

Key advantages of Roth conversions include:

  • Tax-Free Growth and Withdrawals: Once converted and the five-year rule is met, both contributions and earnings grow and can be withdrawn tax-free.
  • No Required Minimum Distributions (RMDs) for Owners: Unlike traditional IRAs, Roth IRAs are not subject to RMDs during the original owner's lifetime. This offers greater control and allows assets to compound tax-free for longer.
  • Tax-Free Inheritance for Heirs: While non-spouse beneficiaries of inherited Roth IRAs are still subject to the 10-year distribution rule, the withdrawals remain income tax-free, provided the account was open for at least five years. This is a significant advantage over inherited traditional IRAs, which are fully taxable.
  • Tax Diversification: Holding assets in a mix of tax-deferred, tax-free, and taxable accounts provides greater flexibility in managing taxable income during retirement.
  • No Income Limits for Conversions: Unlike direct contributions to Roth IRAs, there are no income limits on Roth conversions, making it a viable strategy for affluent individuals.

Managing the Immediate Tax Liability and Other Downsides

The most significant drawback of a Roth conversion is the immediate tax liability incurred on the converted amount. The converted amount is added to the taxpayer's adjusted gross income (AGI) for the year, which can push them into a higher marginal tax bracket. It's crucial that taxes on these conversions are paid from non-retirement funds to maximize the amount available for future tax-free growth within the Roth.

 

To minimize tax impact, consider spreading conversions over multiple years, especially during periods of lower income (e.g., early retirement, career transition). This incremental approach helps manage the overall tax bill and can prevent "bracket jumping."

Beyond income tax, Roth conversions can have other unintended consequences:

  • Medicare Premiums (IRMAA): An increase in AGI from a Roth conversion can lead to higher Medicare Part B and Part D premiums two years later due to Income Related Monthly Adjustment Amounts (IRMAA). Careful planning is essential to avoid crossing IRMAA thresholds.
  • Social Security Taxation: Higher provisional income from conversions can make a larger portion of Social Security benefits taxable.
  • Tax Credits and Financial Aid: Increased AGI may reduce eligibility for certain tax credits or financial aid.
  • The Five-Year Rule: Converted funds must remain in the Roth IRA for at least five years to avoid a 10% early withdrawal penalty on earnings, even if the individual is over 59½. This five-year period starts on January 1 of the year the conversion is made.
  • Permanence: Roth conversions are permanent and cannot be undone (recharacterized).

You should model the impact of conversions over multiple years and consider all potential ripple effects on a client's overall financial picture.

Accelerated Distributions: Accessing IRA Funds Before RMDs

 

Distributions at Age 59½ and Beyond: Penalty-Free Access

Once an IRA owner reaches age 59½, they can generally withdraw funds from their traditional or Roth IRA without incurring the 10% federal early withdrawal penalty. For traditional IRAs, these withdrawals are typically taxed as ordinary income. For Roth IRAs, withdrawals of contributions are always tax-free and penalty-free. Withdrawals of earnings from a Roth IRA are also tax-free and penalty-free if the account has been open for at least five years and the owner is over 59½. This age threshold provides significant flexibility for individuals who wish to access their retirement savings before the mandatory RMD age, which is currently 73 (or 75 beginning in 2033).

 

Substantially Equal Periodic Payments (72(t) SEPPs): Pre-59½ Access Without Penalty

For individuals who need to access their IRA funds before age 59½, Internal Revenue Code Section 72(t) offers an exception to the 10% early withdrawal penalty. This provision allows for "Substantially Equal Periodic Payments" (SEPPs), a series of distributions taken over a specific period without penalty. While the 10% penalty is waived, distributions from a traditional IRA are still subject to ordinary income tax.

 

The SEPP program requires strict adherence to IRS rules to avoid retroactive assessment of the 10% penalty plus interest. Payments must continue for at least five years or until the IRA owner reaches age 59½, whichever period is longer. The IRS provides three approved methods for calculating these SEPP amounts:

  • Required Minimum Distribution (RMD) Method: The annual amount is recalculated each year based on the account balance and life expectancy tables.
  • Fixed Amortization Method: The account balance is amortized over a specific number of years using an assumed interest rate, resulting in a fixed annual payment.
  • Fixed Annuitization Method: This method uses an annuity factor to determine a fixed annual payment.

Breaking the SEPP rules can lead to the retroactive application of the 10% penalty plus interest on all prior distributions. This strategy is complex and typically requires careful calculation and ongoing management, often with professional guidance, to ensure compliance and avoid costly errors.

The "Synthetic Roth Conversion" (IRA Maximization) with Permanent Life Insurance

 

H - Holistic & Transformational: Repositioning Wealth for Max Impact

For clients with substantial IRA balances who aim to leave a significant legacy, the "synthetic Roth conversion," also known as IRA Maximization, presents a compelling alternative or complement to traditional Roth conversions. This strategy involves systematically taking taxable distributions from a traditional IRA and using the after-tax proceeds to pay premiums on a permanent life insurance policy. The core objective is to convert a highly taxed, income-in-respect-of-a-decedent (IRD) asset into a tax-free death benefit for heirs.

 

Strategy Mechanics: Distributions, Premiums, and ILITs

The process begins with the IRA owner taking distributions from their traditional IRA, which are subject to ordinary income tax. Crucially, the taxes on these distributions should be paid from non-retirement assets to maximize the amount transferred to the life insurance policy. The net, after-tax funds are then used to pay premiums for a permanent life insurance policy.

 

To ensure the death benefit is received by heirs free of both income and estate taxes, the life insurance policy should be owned by an Irrevocable Life Insurance Trust (ILIT). An ILIT is a separate legal entity designed to hold life insurance policies outside of the grantor's taxable estate. When the IRA owner passes away, the death benefit from the ILIT-owned policy is paid directly to the trust's beneficiaries, bypassing probate and generally avoiding federal income and estate tax. For this to work, the ILIT should be established first, and the trustee should apply for and own the policy from its inception.

 

The IRA Maximization strategy offers several advantages:

  • Increased After-Tax Legacy: By repositioning taxable IRA assets into tax-free life insurance, beneficiaries can receive a significantly larger after-tax inheritance compared to inheriting the IRA directly.
  • Estate Tax Exclusion: When properly structured within an ILIT, the life insurance death benefit is excluded from the insured's taxable estate, helping to reduce or eliminate federal and state estate taxes.
  • Enhanced Asset Protection: An ILIT can provide asset protection for beneficiaries from creditors and can be customized to control distributions, ensuring responsible behavior.
  • Flexibility: The strategy can be unwound if circumstances changes; the client can simply stop taking distributions (to the extent RMDs allow) and cease transfers to the ILIT.

Structured or Step Premium Approach vs. Level Premium and Premium Finance

Your approach to funding the life insurance component is key. We prefer a structured or step premium approach over level premiums or riskier premium finance strategies.

  • Level Premiums: While predictable, these premiums are fixed throughout the policy's life and often start higher than stepped premiums.
  • Structured or Step Premium Approach: This involves premiums that start significantly lower and are typically locked in until RMDs or later, such as age 59½ when penalty-free IRA access begins. This approach minimizes the initial outlay, which is particularly advantageous when funding premiums with current IRA distributions, as it reduces the immediate tax burden associated with larger withdrawals. These contracts maintain robust guarantee provisions, and the initial premiums are often 60-70% less than their level premium counterparts, offering substantial initial cash flow savings.

The benefits of a structured or step premium approach in IRA Maximization include:

  • Minimized Outlay: Lower initial premiums make the strategy more accessible and less burdensome in the early years, allowing for smaller, incremental IRA distributions and thus smaller immediate tax liabilities.
  • Flexibility: This approach offers greater flexibility to adapt to changing financial circumstances. As income or tax situations evolve, the amount of IRA distributions used for premiums can be adjusted, providing more control over the current tax impact. This contrasts with the fixed nature of level premiums or the rigid commitments of premium finance.
  • Guarantees and Risk Management: While stepped premiums increase with age, the underlying permanent life insurance policy still offers guarantees, such as a guaranteed death benefit and, in many policies, future premium guarantees. The risk of rising costs with stepped premiums must be carefully managed, but the strategy's flexibility allows for adjustments if premiums become unaffordable.
  • Increasing Internal Rate of Return (IRR) at Life Expectancy: By minimizing early outlays and allowing for strategic funding, this approach can potentially optimize the IRR at life expectancy, resulting in a more efficient conversion of premium dollars into a tax-free death benefit.

Comparison to Premium Finance Strategies

We explicitly contrast the structured premium approach with "more risky designed strategies using premium finance strategies." Premium finance involves borrowing funds from a bank or lender to pay for life insurance premiums, leveraging borrowed money to acquire a much larger policy than could be afforded outright. While premium finance can appeal to some IRA holders due to low initial cash flow commitments (like paying interest-only), it introduces several substantial risks:

  • Interest Rate Risk: Variable interest rates can significantly increase the cost of the loan, potentially making the strategy unsustainable.
  • Policy Performance Risk: If the policy's cash value doesn't perform as projected, the loan balance could exceed the policy's collateral value, requiring additional client contributions.
  • Collateral Risk: Lenders often require additional collateral beyond the policy itself, and a drop in collateral value can trigger a margin call.
  • Loss of Control: The lender typically holds rights over the policy, restricting the policyholder's ability to make changes without approval.
  • Complexity and Management: Premium finance is considerably more complex than self-funding and requires careful, ongoing management.

The self-funded, structured premium IRA Maximization strategy, while requiring current income tax payments, avoids these external borrowing risks. It effectively provides "premium finance-like" low initial cash flow commitments without the inherent external risks. It offers greater control, predictability, and flexibility, as the client isn't beholden to a lender's terms, interest rate changes, or collateral calls. This makes it a more conservative and adaptable approach for long-term wealth transfer, especially given the incremental nature of funding through IRA distributions.

Creating a "Synthetic Family Foundation" with DAFs and ILITs

 

T - Transformational and Tax Efficiency: Dual Legacy Impact

For philanthropically inclined clients, combining the IRA Maximization strategy with a Donor-Advised Fund (DAF) can create a powerful "synthetic family foundation." This integrated approach allows for a substantial charitable legacy while simultaneously providing a tax-free inheritance for family heirs.

 

Mechanics of the Combined Strategy

This dual-pronged approach involves:

  • IRA as Beneficiary of DAF: The client designates a Donor-Advised Fund (DAF) as the primary beneficiary of a portion or the entirety of their remaining IRA balance.

 

  • Life Insurance in ILIT for Heirs: Concurrently, the client continues the IRA Maximization strategy, taking distributions from their IRA, paying the income tax, and using the after-tax proceeds to fund a permanent life insurance policy held within an Irrevocable Life Insurance Trust (ILIT) for their family heirs.

Tax Benefits and Legacy Impact

This combined strategy yields significant tax and legacy advantages:

  • Tax-Free Transfer of IRA to DAF: When the IRA owner passes away, the IRA balance designated to the DAF transfers to the DAF tax-free. Public charities, including DAFs, are tax-exempt and do not pay income tax on inherited IRA assets. This avoids the "Income in Respect of a Decedent" (IRD) tax, maximizing philanthropic impact.

 

  • DAF as a Perpetual Charitable Vehicle: A DAF functions much like a private foundation but with less administrative burden and lower costs. Funds contributed to the DAF can be invested for tax-free growth, allowing charitable capital to increase. The donor (or their designated successors) can then recommend grants to qualified public charities over an extended period, even in perpetuity, creating a lasting philanthropic legacy without the complexities of managing a private foundation.

 

  • Estate Tax Reduction via DAF: Donating an asset to a DAF removes it from the donor's taxable estate, reducing potential federal and state estate taxes.

 

  • Income and Estate Tax-Free Life Insurance for Heirs: Simultaneously, the life insurance policy held in the ILIT provides a death benefit that is generally income tax-free to the beneficiaries. Because the policy is owned by the ILIT and not the insured, the death benefit is also excluded from the insured's taxable estate, further reducing estate tax exposure for the family. This ensures the family receives a substantial, untaxed inheritance, providing liquidity and wealth transfer outside the highly taxed IRA structure.

In essence, this combined strategy allows a client to manage their large IRA in a highly tax-efficient manner. The portion directed to charity via the DAF avoids income and estate taxes, maximizing philanthropic impact. The portion converted into life insurance for heirs, managed through an ILIT, bypasses income and estate taxes for the family. This creates a dual legacy: a perpetual charitable giving vehicle mirroring a family foundation, and a substantial, tax-free inheritance for the next generation, all while strategically managing the tax implications of large IRA distributions during the owner's lifetime.

Conclusions and Recommendations

The landscape of retirement and estate planning for clients with large IRAs has been significantly reshaped by SECURE Act 2.0, demanding a proactive and sophisticated approach to wealth transfer. The shift to a mandatory 10-year distribution rule for most inherited IRAs creates a "tax acceleration trap," where beneficiaries face concentrated income tax liabilities over a compressed period, potentially eroding the intended legacy. While exceptions exist for Eligible Designated Beneficiaries, such as the "Age 21 Cliff" for minor children, these also require forward-looking planning.

 

To navigate these complexities, financial advisors should consider a multi-faceted strategy, guided by the FLIGHT diagnostic process:

  • Strategic Roth Conversions: For clients anticipating higher future tax rates or wishing to provide a tax-free inheritance, incremental Roth conversions can be highly effective. By carefully managing the conversion amounts to avoid pushing into higher tax brackets or triggering increased Medicare premiums (IRMAA), clients can proactively shift future tax liabilities to the present, often at a lower overall cost.

 

  • "Synthetic Roth Conversion" (IRA Maximization) with Structured Permanent Life Insurance: This strategy offers a powerful mechanism to transform highly taxed IRA assets into a tax-free death benefit for heirs. By taking calculated IRA distributions, paying the current income tax, and using the net proceeds to fund a permanent life insurance policy held within an Irrevocable Life Insurance Trust (ILIT), clients can significantly increase the after-tax wealth transferred to their beneficiaries. The use of a "structured or step premium" approach minimizes initial outlay and provides greater flexibility, optimizing the Internal Rate of Return (IRR) at life expectancy compared to more rigid or risky premium finance strategies. This self-funded approach avoids the interest rate, collateral, and control risks associated with borrowing.

 

  • "Synthetic Family Foundation" via DAFs and ILITs: For philanthropically inclined clients, integrating a Donor-Advised Fund (DAF) as an IRA beneficiary alongside the ILIT-held life insurance strategy creates a robust legacy plan. The IRA balance transfers tax-free to the DAF, establishing a perpetual charitable giving vehicle. Simultaneously, the life insurance proceeds pass income and estate tax-free to family heirs. This dual approach maximizes both charitable impact and family inheritance, providing a sophisticated alternative to private foundations.

It is imperative for advisors to conduct thorough financial modeling and collaborate closely with tax and legal professionals to tailor these advanced strategies to each client's unique financial situation, risk tolerance, and legacy goals. Proactive planning, rather than reactive measures, is the cornerstone of optimizing large IRAs for multi-generational wealth transfer in the current tax environment.