Inherited IRAS Won’t Stretch As Far As They Used To

SECURE Act and Stretch IRAS

Up until 2020, the “stretch IRA” concept was commonly used as an estate or legacy planning tool for IRA owners who wanted to leave a significant amount of tax-sheltered assets to their heirs. With the passage of the Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act), this strategy is no longer available for certain types of beneficiaries. The SECURE Act eliminated the distribution option that allowed certain beneficiaries to stretch out the required payments from inherited IRA assets over their lifetime. The new beneficiary distribution rules may affect the beneficiaries you have named to inherit your IRAs or your own inheritance if you will inherit IRA assets after January 1, 2020.

The Stretch IRA Concept

Individuals who inherit IRA assets are required to deplete the inherited IRA within a certain number of years. Under the rules prior to the SECURE Act, beneficiaries had multiple options for scheduling the withdrawal of money out of an inherited IRA. One of those options was to take a minimum payment each year, calculated based on either the beneficiary’s or the IRA owner’s remaining life expectancy. This option allowed beneficiaries to spread out the tax liability of their inheritance over the course of many years and to let the IRA investment continue growing tax-deferred for as long as possible. When beneficiaries take only the minimum required payment each year with the objective of keeping as much of the IRA invested for as long as possible, it’s referred to as the “stretch IRA” strategy. Depending on the age of the beneficiary, the payments could be stretched over many years. This strategy also maximizes the amount of IRA assets available to future generations.

For example:

•  Dad, the IRA owner, takes the minimum amount required from his IRA during his lifetime (based on the required minimum distribution (RMD) rules) to maximize what’s left for his daughter, who is named as the IRA beneficiary.

•  Daughter, as beneficiary after Dad’s death, takes only the minimum payment required each year under the life expectancy payment option to “stretch” the payments over her lifetime. Daughter names her son as beneficiary of her inherited IRA and dies before depleting the IRA.

•  Son of the original beneficiary (and grandson of the IRA owner), as successor beneficiary after Mom’s death, continues to take only the minimum annual required payments to extend the tax-sheltered growth of the IRA and spread his tax liability over his mother’s remaining life expectancy.

What the SECURE Act Changes

The SECURE Act changes the beneficiary distribution options by eliminating the life expectancy payment option for most beneficiaries. Beneficiaries who inherit retirement savings on or after January 1, 2020, must deplete the inherited IRA assets within 10 years following the year of the IRA owner’s death unless a beneficiary qualifies as an “Eligible Designated Beneficiary” (defined below). Beneficiaries subject to the 10-year rule may choose to take zero withdrawals from the inherited IRA until the 10th year to allow the IRA investments to continue growing tax-deferred for as long as possible under the new rules. However, this beneficiary will face a potentially large tax bill in the 10th year when they must withdraw the entire balance in the IRA. Alternatively, a beneficiary may choose to take a portion of the balance out of the IRA every year, or every other year, or in any frequency they choose, to help mitigate the tax liability of the inheritance. (Of course, if a Roth IRA is inherited, distributions will generally be tax-free to the beneficiary.)

Beneficiaries should seek financial planning and tax advice to explore the tax consequences for various payment frequencies under the 10-year rule to find the option that is the most beneficial considering their tax-filing status and tax bracket. For example, a tax professional may help beneficiaries calculate how much additional taxable income they could withdraw from the inherited IRA each year (for 10 years) to ensure they stay within their current tax bracket each year.

Eligible Designated Beneficiary (EBD)

The SECURE Act exempts certain types of beneficiaries from the 10-year distribution rule. The following types of beneficiaries are now referred as “eligible designated beneficiaries.” They may continue to follow the distribution options available before the SECURE Act, which includes taking life expectancy payments and stretching an inherited IRA.

Eligible Designated Beneficiaries Not Subject to the 10-Year Rule
•  Surviving spouse of the IRA owner
•  Minor child of the IRA owner*
•  Disabled individual
•  Chronically ill individual
•  Nonspouse beneficiary who is less than 10 years younger than the IRA owner

*A minor child may take life expectancy payments until they reach the age of majority. At the age of majority, they become subject to the 10-year rule.

Beneficiaries who inherited retirement savings prior to 2020 may also continue to take beneficiary payments under the old rules. If they die with assets left in the inherited IRA, their beneficiaries will generally be required to take distributions under the 10-year rule.

More Information Coming

Many of the details surrounding these new rules need to be clarified by the IRS. In the meantime, IRA owners may want to review their beneficiary designations and evaluate the overall impact these rules may have on their legacy planning. Beneficiaries who inherit IRA assets should consult with a financial and/or tax advisor to be sure they understand the options available to them.

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