The recently-signed SECURE Act implemented significant changes to the current rules for contributing to and distributing from an IRA. These changes will likely affect the beneficiaries of your retirement accounts and may require you to revisit your estate planning.
The new 10-year rule
Under the previous rules, a beneficiary of a tax-deferred retirement account, such as a 401(k) or IRA, could withdraw the required minimum distributions (RMDs) over his lifetime. Because withdrawals from these accounts are typically taxable as ordinary income, the ability to “stretch” the payments out over a lifetime minimizes a beneficiary’s tax burden by allowing him to withdraw smaller taxable amounts annually over a longer period. This often prevents beneficiaries from being pushed into a higher tax bracket.
Under the SECURE Act, funds in an inherited IRA would be required to be withdrawn (and therefore taxed) by the end of the 10th year following the account owner’s death, instead of over the beneficiary’s lifetime, greatly increasing the tax cost to the beneficiary. The beneficiary can withdraw her distributions over those 10 years, or she can withdraw the funds all in the 10th year (not usually recommended because of the resulting higher tax bracket).
Exceptions to the 10-year rule
The following “eligible designated beneficiaries” are excepted from this new 10-year rule and maintain the ability to stretch distributions over their lifetime:
Note: The exception for minor children is limited to the account owner’s children only, not the account owner’s grandchildren or other minor beneficiaries. Once the account owner’s child reaches the age of majority (age 18 in many states, perhaps later if the IRS takes continued higher education into account), the 10-year rule then applies to the remaining IRA assets.
How the 10-year rule affects beneficiaries
Let’s put this significant rule change into context:
Your 19-year-old (who is not an “eligible designated beneficiary”) inherits a $500,000 IRA from his grandparent. Prior to the SECURE Act rules, he was required to withdraw approximately $7,800 annually in RMDs based on his life expectancy calculation.
Under the SECURE Act, the entire account balance would have to be withdrawn by the end of the 10th year following his grandparent’s death. This would require your child to make an annual withdrawal of approximately $45,000-$50,000, with the money taxed as ordinary income in most cases.
This new legislation is effective for all account owners whose deaths occur after December 31, 2019. For those who died prior to January 1, 2020, beneficiaries will not be subject to the new 10-year rule and may continue taking required minimum distributions based on their life expectancy. However, if those beneficiaries die before the assets in the account are completely distributed, the subsequent beneficiaries of the remaining assets will be subject to the 10-year rule (whereas previously, these subsequent beneficiaries were allowed to continue taking RMDs based on the life expectancy of the first, deceased beneficiary).
Concerns around conduit trusts
Families with “conduit trusts” will be affected because this trust structure requires that any distributions the trust receives from the IRA must be passed directly to the beneficiaries and not held in the trust. Condensing the IRA payout period to 10 years not only increases the tax burden on these beneficiaries, but also gives them unfettered access to the entire IRA balance much sooner than was likely intended by the trust’s creators.
Of particular concern are conduit trusts established for minor grandchildren, as grandchildren do not qualify for the life expectancy payout and would receive distributions over a 10-year period, instead of the previously expected payout of 60 to 80 years for a minor beneficiary.
Contribution and RMD changes for account owners
The SECURE Act also pushes back the start of RMDs to age 72 from the current age of 70 ½, effective for account owners reaching 70 ½ after December 31, 2019 (note that financial institutions have until April 15, 2020, to correct erroneous 2020 RMD notifications for taxpayers whose RMD was pushed back by SECURE). Account owners remain eligible to make qualified charitable distributions beginning at age 70 ½, despite the age change for RMDs.
The legislation also allows account owners to continue contributing to their IRAs beyond age 70 ½, while they are still working, which was not previously allowed. Note that a pre-tax contribution to your IRA after age 70 ½ offsets any qualified charitable distribution made in that or subsequent years.
Consider alternate planning strategies
Now is the time to review your IRA beneficiaries and examine how your tax-deferred retirement accounts fit into your estate plan. Your attorney can help you fix issues with beneficiaries or trusts, and determine the cost and feasibility of alternate strategies. Please see our article, “5 Tax-efficient IRA Planning Strategies under the SECURE Act,” for information about alternatives you may want to consider.