If you plan on leaving IRA and retirement plan assets to heirs — or if you stand to inherit retirement assets — the federal spending package, which included the Setting Every Community Up for Retirement Enhancement (SECURE) Act, at the end of 2019, has brought new rules and distribution options you should be aware of.
Chief among them is the effective elimination of the “stretch IRA,” which is an estate-planning strategy that allowed an IRA to continue benefiting from tax-deferred growth, potentially for decades. Most nonspouse beneficiaries, including children and grandchildren, can no longer “stretch” distributions over their lifetimes. More about the new rules are explained below:
As of January 2020, most nonspouse beneficiaries are required to liquidate inherited accounts within 10 years of the owner’s death. This shorter distribution period can result in unanticipated and potentially large tax bills for nonspouse beneficiaries who inherit high-value IRAs. However, there are no annual required minimum distributions (RMDs) during the 10-year period, so beneficiaries can take distributions in any amount and any time frame they choose, provided the assets are completely exhausted at the end of the period. Any funds not liquidated by the 10-year deadline are subject to a 50% penalty tax.
For beneficiaries of a traditional IRA, spreading the distributions equally over the 10 years can be one way to manage the annual tax liability. In some cases, it may be helpful for a beneficiary to take distributions in low-earning years. For younger clients, this may be earlier in the ten-year distribution term as they may have higher earnings in later years. For older clients, it may make sense to wait till retirement, so that they are not pushed into a higher tax bracket, if the ten-year distribution term allows.
On the other hand, beneficiaries of a Roth IRA — which generally provides tax-free distributions — might want to leave the account intact for up to 10 years, allowing it to potentially benefit from tax-free growth for as long as possible.
Notable exceptions
The new rules specifically affect most nonspouse designated beneficiaries who are more than 10 years younger than the original account owner. However, key exceptions apply to those who are known as “eligible designated beneficiaries”:
- a spouse of the account owner1;
- a minor child of the account owner (note that the 10-year distribution rule will apply once a child beneficiary reaches the age of majority, or when a successor beneficiary inherits account funds from an initial eligible designated beneficiary);
- those who are not more than 10 years younger than the account owner (such as a close-in-age sibling or other relative);
- disabled or chronically ill individuals, as defined by the IRS.
Eligible designated beneficiaries may use the old stretch IRA rules and take RMDs based on their own life expectancies.2 In these cases, RMDs must begin no later than December 31 of the year after the original account owner’s death. However, if the original owner was of RMD age and failed to take the required amount in the year of death, the beneficiary must take the RMD by December 31 of that year. Failure to take the appropriate amount can result in a penalty equal to 50% of the amount that should have been withdrawn.
Another rule that remained consistent with the old rules is the option that the beneficiary can disclaim an inherited retirement account. This may be appropriate if the initial beneficiary does not need the funds and/or want the tax liability. In this case, the assets may pass to a contingent beneficiary who has greater financial need or may be in a lower tax bracket. A qualified disclaimer statement must be completed within nine months of the date of death.
Impacts on trust planning
Prior to 2020, individuals with high-value IRAs often used conduit — or “pass-through” — trusts to manage the distribution of inherited IRA assets. The trusts helped protect the assets from creditors and helped ensure that beneficiaries didn’t spend down their inheritances too quickly. However, conduit trusts are now subject to the same 10-year liquidation requirements, in most cases, so the new rules may render null and void some of the original reasons the trusts were established.
Planning tips
Retirement account owners should review their beneficiary designations with their financial or tax professional and consider how these new rules may affect inheritances and taxes. Close consideration should be paid to any strategies that include trusts as beneficiaries. Other strategies that account owners may want to consider include converting traditional IRAs to Roths; bringing life insurance, charitable remainder trusts, or accumulation trusts into the mix; and planning for qualified charitable distributions.3
Please reach out to us if you have any questions about these new rules!
1The surviving spouse of an original account owner who was under RMD age at the time of death can wait until December 31 of the year in which the deceased would have had to take RMDs, or the spouse can roll over the IRA assets to their own IRAs or elect to treat a deceased account owner’s IRA as their own (presuming the spouse is the sole beneficiary and the IRA trustee allows it). By becoming the account owner, the surviving spouse can make additional contributions, name new beneficiaries, and wait until age 72 to start taking RMDs.5 (A surviving spouse who becomes the account owner of a Roth IRA is not required to take distributions).
2If the original account owner dies on or after the required beginning date, an older eligible designated beneficiary can take RMDs over the remaining life expectancy of the original account owner if it is longer than the beneficiary’s life expectancy.
3Other trusts are generally subject to RMDs based on the owner’s life expectancy if the owner had reached the required beginning date; if the owner died before the required beginning date, the account must be emptied by the end of the fifth year after the owner’s death. There are costs and ongoing expenses associated with the creation and maintenance of trusts.