The Setting Every Community Up for Retirement Enhancement (SECURE) Act contains a number of favorable provisions that will help Americans save more for retirement. However, the new law also contains an unfavorable provision that will affect nonspouse IRA beneficiaries who inherit accounts with substantial balances. As a result, some carefully constructed estate plans will be damaged. Here’s the story.
Before the SECURE Act, the required minimum distribution (RMD) rules allowed a nonspouse beneficiary to gradually drain inherited IRAs over the beneficiary’s IRS-defined life expectancy.
For example, Ann is 40 years old when she inherits her elderly Aunt Lilly’s $500,000 Roth IRA. The current IRS life expectancy table estimates that Ann will live for another 43.6 years.
Ann must start taking annual RMDs from the inherited account by dividing the account balance as of the end of the previous year by her remaining life expectancy as of the end of the current year. So, her first RMD would equal the account balance as of the previous year end divided by 43.6, which would amount to only $11,468, or 2.29% of the balance ($500,000 divided by 43.6 years). Her second RMD would equal the account balance as of the end of the following year divided by 42.6, which translates to only 2.35% of the balance. And so on until the account is fully depleted.
Before the SECURE Act, the RMD rules allowed nonspouse beneficiaries to keep an inherited account open for many years and reap the tax advantages for those years. With an IRA, this is sometimes called the “stretch IRA” strategy. It’s particularly advantageous for inherited Roth IRAs, because the income those accounts produce can grow and be withdrawn free from federal income tax. So, under the pre-SECURE Act RMD rules, a stretch Roth IRA could provide protection from future federal income tax rate increases for many years.
The SECURE Act requires most nonspouse IRA and retirement plan beneficiaries to empty inherited accounts within 10 years after the account owner’s death. This is an unfavorable change for beneficiaries who would like to keep inherited accounts (generally traditional and Roth IRAs) open for as long as possible to continue reaping the tax advantages.
This change won’t affect account beneficiaries who want to quickly drain inherited accounts or account owners who empty their accounts during their retirement years. It only affects certain nonspouse beneficiaries who want to keep inherited accounts open for as long as possible to reap the tax advantages.
This change also won’t immediately affect accounts inherited by a so-called “eligible designated beneficiary.” This term refers to:
The surviving spouse of the deceased account owner,
A minor child of the deceased account owner,
A beneficiary who’s no more than 10 years younger than the deceased account owner, or
A chronically ill individual as defined under the tax law.
Other nonspouse beneficiaries will get hit by the new 10-year account liquidation requirement. For example, continuing with the previous hypothetical situation, Ann could only keep the Roth IRA that she inherited from Aunt Lilly open for 10 years after her death, if Aunt Lilly dies in 2020 or later.
Important: Under the exception for eligible designated beneficiaries, RMDs from the inherited account can generally be taken over the life or life expectancy of the eligible designated beneficiary, beginning with the year following the year of the account owner’s death.
The unfavorable changes to the RMD rules under the SECURE Act are generally effective for RMDs taken from accounts whose owners die after 2019. The RMD rules for accounts inherited from owners who died before 2020 are unchanged.
For More Information
Nonspouse beneficiaries should be aware of the changes to the rules for draining inherited accounts. If you inherit a traditional or Roth IRA with a substantial balance, contact our firm to determine if the unfavorable 10-year rule applies to you and to answer any other questions you have about minimizing taxes on distributions.
In addition, individuals who were relying on the Stretch IRA strategy as part of their estate plan will have to rethink things. We can help with that, too.