Since the Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law on December 20, 2019, a whole slew of changes surrounding retirement accounts has come into existence (we summarized some of those changes here). One such change is the elimination of the “stretch IRA,” or the ability of the beneficiary of a qualified IRA to take mandatory distributions from the account based on their own life expectancy. This gave the beneficiary a longer time frame in which to liquidate the account, effectively lowering the beneficiary’s tax burden when compared to the distributions that would have taken place if the original IRA owner had not passed away. Now, under the SECURE Act, beneficiaries of IRAs must deplete the entire account by December 31 of the 10th anniversary year of the IRA owner’s death. Below, we explore the implications of this change and planning strategies to consider, whether you are thinking of leaving an IRA to your heirs or believe you will inherit an IRA in the future.
A Brief Recap of Required Minimum Distributions (RMDs)
Since Individual Retirement Accounts (IRAs) were established by the Establishing Retirement Income Security Act (ERISA) of 1974, the government has mandated that those with IRAs must distribute a certain portion of these accounts via required minimum distributions (RMDs) upon reaching a certain age. Initially, that age was 70 ½, but the SECURE Act raised the age to 72 for anyone who turned 70 ½ after January 1, 2020. (Note: Similar requirements exist for 401(k) accounts, but we will focus on IRAs in this article.)
Allowing people to contribute to (Traditional) IRAs gives them a tax advantage, since they can deduct the contributions from their income, and all dividends, interest, and capital gains are tax-deferred. Eventually, however, the IRS wants to tax the money in the IRA, whether during the account owner’s lifetime or that of their heirs.
RMDs for Inherited IRAs Under the SECURE Act
Under the SECURE Act, beneficiaries who inherit an IRA after January 1, 2020, must distribute the entire account within 10 years of inheriting it, eliminating the “stretch” IRA for most beneficiaries. Notably, there is no requirement for annual distributions, giving beneficiaries a bit of flexibility as to how they distribute the money. Additionally, the Act does allow five types of beneficiaries—called “eligible designated beneficiaries” (EDBs)—to maintain the old RMD rules, taking distributions based on their life expectancy: 1) the owner’s surviving spouse; 2) children of the owner who are younger than 18; 3) disabled individuals; 4) chronically ill individuals; and 5) any others who are not more than 10 years younger than the deceased.
Planning for Leaving an IRA to a Beneficiary
If you plan on leaving an IRA as an inheritance, these new rules may affect how you plan to distribute the account (and other assets) to your heirs. Consider the following when making these decisions:
1. Beneficiary Review: If you would like to avoid having your beneficiaries distribute the account within 10 years, make sure they qualify as EDBs (as described above).
2. Other Estate Assets: Perhaps you know you want to leave a certain amount of money to specific beneficiaries, but do you have assets outside of your IRA you can leave them to accomplish that goal? If so, perhaps this allows you to name a beneficiary who is an EDB.
3. Name a Charity as Beneficiary: This strategy is especially compelling if you are already planning to leave money to charity. Rather than leaving the IRA to another person, consider designating a charity as your beneficiary. Many people would rather leave 100% of the account to charity instead of the after-tax amount to their children.
Planning for Inheriting an IRA (as a Non-EDB)
While it is difficult to plan for something you may not even know about (not all IRA owners tell their beneficiaries they are leaving the account to them), it is good to know your options in case you ever find yourself inheriting an IRA. Knowing you must deplete the account within 10 years, the most important thing to consider is your marginal tax rate (the highest tax bracket your income is subject to).
Since all of the money distributed from the account will be taxed at ordinary income rates, it is important to know what your marginal tax rate currently is and what you believe it might be in the future. If you think you will be in a higher tax rate later on, it may make sense to distribute more of the account now, while you are in a lower marginal tax bracket. However, perhaps you plan to retire before 10 years and believe you will be in a lower tax bracket at that time. Then, consider waiting until after retirement to begin distributions from the inherited account.
Planning for the distribution of a retirement account can get complicated fast. If you believe you could use some help planning for your own IRA or one you have inherited, find a qualified financial advisor and/or CPA to help you navigate these complexities.
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.