In 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) repealed a key legacy planning provision that used to allow designated IRA beneficiaries to take inherited distributions over the course of their lifetime. Not only did this allow the money within the IRA to keep growing, but allowed the beneficiary to spread their tax liability on distributions out over time. Now, however, designated beneficiaries must distribute these IRAs within 10 years.
But, 2020 returns raised some questions as to how this 10-year rule will work in practice, specifically in regards to RMDs. Unfortunately, publications released by the IRS this past year further complicated understanding. Word through the IRA grapevine is that the IRS will clear up any confusion in proposed RMD regulations that will be issued soon.[i]
In the meantime, clarification on the following six points should be helpful.
Part I: The New Laws
1) The elimination of the stretch IRA[ii]
A designated beneficiary is the person or trust positioned to inherit an IRA from an individual, once that individual passes. Before 2019, non-spousal beneficiaries had several options for taking distributions from the account. One popular option was taking required minimum distributions (RMDs) from the account based on the life expectancy of the beneficiary, especially if they were younger than the original account owner.[iii]
By taking RMDs over their lifetime, beneficiaries could stretch the tax-deferred growth of the account. This strategy also offered the tremendous opportunity to preserve the asset and pass it on to the next generation.
The Secure Act essentially eliminated the stretch IRA for most non-spousal beneficiaries for IRAs inherited on or after January 1, 2020. IRAs inherited prior to that date are still eligible to continue with RMDs as before.
2) The age of the owner at death is immaterial for a designated beneficiary[iv]
The 10-year rule applies to a designated beneficiary regardless of the age at which the IRA owner dies. As a result, it is no longer necessary to determine the age of the IRA owner at the time of death for distribution purposes if the IRA owner died after 2019 and the beneficiary is a designated beneficiary.
3) Distributions are optional until the end of year 10[v]
For designated beneficiaries who are subject to the 10-year rule, distributions are optional until December 31 of the tenth year that follows the year in which the IRA owner dies.
4) 10-year Rule applies to successor beneficiary of a pre-2020 beneficiary taking distributions over her life expectancy who dies after 2019[vi]
If a designated beneficiary inherited an IRA before 2020 and was taking distributions over their life expectancy, their successor beneficiary would take distributions over what remained of their—the designated beneficiary’s—life expectancy. However, this option to take distributions over what remained of the designated beneficiary’s life expectancy applies only if the designated beneficiary died before 2020. If such a designated beneficiary dies after 2019, the successor beneficiary is subject to the 10-year rule. This 10-year period starts the year that follows the year in which the designated beneficiary dies.
5) 10-year rule applies to successor beneficiary of “eligible designated beneficiary” taking distributions over their life expectancy[vii]
“Eligible designated beneficiary” is a new category of beneficiary that was created under the SECURE Act and applies only to IRAs inherited after 2019. These beneficiaries are:
- The surviving spouse of the IRA owner.
- A child of the IRA owner who has not reached the age of majority, as defined under state law. Once the child reaches the age of majority, that child becomes a regular designated beneficiary and has 10 years (after reaching the age of majority) to distribute the inherited IRA.
- Disabled as defined by the social security administration.
- Chronically ill and subject to meeting certain specific requirements.
- An individual not described in any of the previous categories who is not more than 10 years younger than the IRA owner.
An eligible designated beneficiary is eligible to take distributions over their life expectancy, and in doing so, their successor beneficiary would then be subject to the 10-year rule. This 10-year period starts the year that follows the year in which the eligible designated beneficiary dies.
6) IRA inherited by beneficiary who is a minor would later be subject to the 10-year rule[viii]
If the eligible designated beneficiary is a minor child of the IRA owner, they are eligible to take distributions over their life expectancy. As stated above, a minor child of the IRA owner would be an “eligible designated beneficiary” and his/her successor beneficiary would be subject to the 10-year rule upon his death. However, this applies only if the minor child dies before reaching the age of majority, as defined under State law.
There is an added layer for a beneficiary who is a minor child of the IRA owner, where the distribution option is switched from the life expectancy option to the 10-year rule when the minor child reaches the age of majority as defined under State law.
Penalties to Avoid
Beneficiaries who fail to take RMDs by the applicable deadline will owe the IRS a 50% excess accumulation penalty of any RMD shortfall. This includes those who are subject to the 10-year rule and fail to fully distribute the account by the end of the 10-year period.
Part II: Planning Tips[ix]
With these changes in mind, the following estate and tax planning strategies might be worth exercising.
1) Consider Your Spouse as Your First Beneficiary
Consider naming a spouse as the primary beneficiary of your IRAs (rather than a non-spouse) to allow for continued tax-favored growth without the aggressive 10-year timeline for withdrawals. Although the spouse beneficiary is still subject to RMDs from that account based on their life expectancy, those withdrawals will likely be less than what would be required under a 10-year withdrawal plan.
2) Convert Your IRA to a Roth
Now that the income schedule has been accelerated for beneficiaries, it may advantageous to pass along Roth assets without RMDs as opposed to traditional IRAs with required RMDs.
Looking Forward
Estate planning may have gotten a bit trickier, and stickier, as a result of these new provisions to inherited IRA rules; but, investors are not without options. Consult with your trusted financial professional today about taking these changes into account in both your estate plans and beneficiary designations.
If you are in need of a comprehensive wealth planner who can integrate your current and future needs into a simple retirement and legacy plan that will work for you, schedule a call with one of our advisors today. URS Advisory serves clients locally on the Treasure Coast and in the Palm Beaches. We look forward to speaking with you.
[i] https://www.thinkadvisor.com/2021/04/26/irs-to-revise-guidance-that-caused-confusion-on-inherited-iras-report/ 2 August 2021
[ii] https://www.forbes.com/sites/bobcarlson/2021/01/22/mistakes-ira-beneficiaries-are-making-after-the-secure-act/ 2 August 2021
[iii] https://www.fidelity.com/learning-center/personal-finance/retirement/non-spouse-IRA 2 August 2021
[iv] https://www.irs.gov/retirement-plans/required-minimum-distributions-for-ira-beneficiaries 2 August 2021
[v] https://www.schwab.com/ira/inherited-ira/withdrawal-rules 2 August 2021
[vi] https://www.kiplinger.com/retirement/retirement-plans/required-minimum-distributions-rmds 2 August 2021
[vii] https://www.thinkadvisor.com/2021/04/26/irs-to-revise-guidance-that-caused-confusion-on-inherited-iras-report/ 2 August 2021
[viii] https://www.investopedia.com/articles/personal-finance/102815/rules-rmds-ira-beneficiaries.asp 2 August 2021
[ix] Ibid.