Now that the dust has settled a bit on the SECURE Act, it is worth further considering how the new law affects beneficiaries who inherit Individual Retirement Accounts (IRAs). Before the SECURE Act, a beneficiary of an inherited an IRA account could stretch required minimum distributions (“RMDs”) over his or her own life expectancy, only gradually withdrawing funds over a lifetime. No more. For any IRA inherited after January 1, 2020, a beneficiary must now withdraw the entire IRA account – whether a traditional or a Roth IRA — within 10 years of the account owner’s death unless one of the exceptions to the 10-year rule applies.
Exceptions for Spouse
The good news is that under the SECURE Act, the surviving spouse can still stretch out inherited IRA benefits over his or her lifetime rather than having to withdraw the account proceeds within 10 years of the account owner’s death. Be aware that at the death of the surviving spouse, the stretch treatment terminates and the 10-year payout rule applies to the next person to inherit the IRA.
A surviving spouse, as before, has two main options for how to treat an inherited IRA. First, the surviving spouse can elect to roll over the inherited IRA to his or her own IRA account. For traditional rollover IRAs, the surviving spouse does not have to take RMDs until age 72, and if the rollover is a Roth IRA, the surviving spouse is not required to take RMDs during his or her lifetime.
Second, a surviving spouse may elect to have the IRA classified as an inherited IRA and take RMDs based on his/her own life expectancy starting at the later of (1) December 31st of the year after the IRA owner dies; or (2) December 31st of the year in which the deceased IRA owner would have reached age 72, regardless of the surviving spouse’s age.
One important advantage of choosing inherited IRA treatment for a traditional IRA is that the surviving spouse can make withdrawals from the IRA before age 59 ½ without incurring a 10% excise tax on early withdrawals. That is critical if a surviving spouse is younger and needs the money from an IRA for living expenses.
Other Exceptions to the 10-Year Rule
Beneficiaries who are disabled or chronically ill may also stretch out IRA RMDs over their own life expectancies, rather than having to withdraw funds from the IRA under the 10-year rule. To qualify for the life expectancy payout, the beneficiary must be disabled or chronically ill (under the IRS definitions) at time of the IRA owner’s death.
The IRA owner’s minor children (but not grandchildren) can also take distributions based on their own life expectancies until reaching the age of majority, which is typically eighteen. After reaching the age of majority, the beneficiary must then withdraw the rest of the IRA within 10 years.
Finally, certain individuals who are not more than 10 years younger than the IRA account owner, can also stretch out RMDs based on their own life expectancies. This may work well for those who want to leave IRA benefits to a sibling, significant other or a friend who is close in age. As with the above exceptions, the life expectancy payout terminates at the death of the individual who inherited the IRA and the 10-year payout rule applies to the successor beneficiary.
The 10-Year Rule Applies to Everyone Else
For those who do not qualify for one of the above exceptions, the 10-year payout rule applies, limiting the tax-deferred growth of IRA assets. Unfortunately, receiving IRA distributions over a shorter time period may bump a beneficiary into higher tax bracket.
There are potential strategies to mitigate the tax bite of receiving an accelerated IRA payout. Possibilities include:
- leaving an IRA to heirs in a lower tax bracket;
- leaving an IRA to a greater number of beneficiaries to lower the tax burden;
- converting a traditional IRA to a Roth IRA; or
- using life insurance to fund an inheritance in place of an IRA.
There is no one size fits all solution. How to distribute IRAs and other retirement accounts to heirs depends on your particular objectives, and is a good reason to take a fresh look at your estate planning to determine if adjustments are needed following the SECURE Act.