New Rules for Inherited IRAs
There are new rules for IRA’s inherited after January 1, 2020, and it may impact estate planning for existing IRA owners. The SECURE Act signed by former President Trump at the end of 2019 eliminated the “stretch IRA,” an estate planning strategy that allowed an Inherited IRA to continue benefiting from tax-deferred growth for potentially decades.
Individuals who plan to leave retirement assets and Individual Retirement Accounts (IRAs) to their heirs as well as individuals who may inherit retirement assets should understand the implications of the recent changes. For purposes of this article, we will address changes that effect non-spouse beneficiaries, such as children or grandchildren, for example. The rules are different for spouses, and we will address those in a future article.
The old rules still apply for IRA’s inherited prior to December 31, 2019. Under the old rules a non-spouse beneficiary had to begin Required Minimum Distributions (RMDs) in the year following the death of the retirement account holder. However, the annual distributions could be calculated based on the beneficiary’s life expectancy. Typically, beneficiaries are children or grandchildren with a much longer life expectancy than the decedent so the annual distributions would be significantly smaller. The ability to stretch taxable distributions over the beneficiary’s lifetime helped reduce their annual tax burden and allowed them to benefit from tax deferred growth.
Under the new rules, for retirement assets inherited beginning January 1, 2020, most non-spouse beneficiaries must fully disburse the account within 10 years of the owner’s death. This shorter distribution period could result in potentially large tax bills that were not anticipated, particularly for those who inherit large IRA accounts. There are no RMDs in the 10-year period so beneficiaries can choose any time frame within the 10-year period. However, any funds not liquidated by the 10-year deadline are subject to a 50% penalty.
These new rules impact most non-spouse beneficiaries who are more than 10 years younger than the original owner of the retirement account. However, there are a few notable exceptions to the non-spouse rules above. Exceptions apply to a spouse, minor child, those who are less than 10 years younger than the original account holder, and disabled or chronically ill individuals, as defined by the IRS. Collectively, these are known as “eligible designated beneficiaries.”
The impact of the changes is a potentially higher tax bill for the beneficiaries of IRAs. As a result, Roth conversions during the life of the IRA owner may be even more beneficial. If an IRA owner converts traditional IRA assets to a Roth IRA, the taxes on those funds are pre-paid at the time of conversion. The Roth IRA will continue to grow tax free during the life of the owner and will eventually pass to the IRA beneficiary with no income tax due on distributions from the account. Even though inherited Roth IRA’s must also be distributed within 10 years, the beneficiary can simply wait the full 10-year period to get the maximum benefit from tax free growth and then distribute the entire account at the end of the 10-year period without incurring additional income tax.
Of course, the biggest mistake IRA owners make when naming an IRA beneficiary is confusing “beneficiary” with “Executor” or “Trustee”. These are not the same, and the new rules make the mistake even more damaging. The beneficiary of an IRA is the person designated to inherit the assets, not the person responsible for distributing the assets. It is important to list all the individuals chosen to inherit the funds. This approach spreads the tax burden across all the beneficiaries. For example, rather than naming your oldest child as the beneficiary and then telling your oldest to share the inheritance, name each of the children so that each child can use their own tax brackets.
We recommend that you consult with your CPA or estate attorney to make the best planning decisions for your circumstances. If you would like to discuss your situation, please feel free to give us a call.