A key component of the SECURE Act, which became law earlier this month, involves how beneficiaries can withdraw funds from inherited retirement accounts. With the new law, beneficiaries of individual retirement accounts (IRAs) and 401(k) plans must withdraw all assets from inherited accounts within 10 years, though they do not have to take required minimum distributions (RMDs). Prior to the SECURE Act, beneficiaries could spread withdrawals out over their life expectancy.
The SECURE Act removes the ability to spread out inherited IRA withdrawals and the tax consequences associated with them, which means higher tax bills, especially for beneficiaries who are in their peak earning years.
When does the 10-Year Rule Start?
The 10-year rule under the SECURE Act takes effect on January 1, 2020 and applies only to retirement accounts belonging to individuals who pass away in 2020 and beyond. Therefore, if you have clients who are already taking RMDs from an IRA they inherited during or before 2019, they can still take distributions over their life expectancy—the 10-year rule does not apply.
Spousal vs. Non-Spousal Beneficiaries
Exceptions do exist for the 10-year rule. Most notably, an individual who inherits IRAs or 401(k) plans from their spouse can continue to stretch withdrawals over their life expectancy. Disabled beneficiaries and individuals who are not more than 10 years younger than the account holder, such as a younger sibling, are also exempt from the rule. Minor children are another exception but only until they reach majority age. The 10-year limit begins when they turn 18.
Withdrawal Strategies for the 10-Year Rule
A beneficiary’s withdrawal strategy will vary greatly depending on their financial situation. They should consider their income-tax rate as well as their retirement plans, both of which can have an impact on their inherited IRA withdrawal strategy. For example, beneficiaries who are within 10 years of retirement would benefit from delaying withdrawals from these inherited accounts until after they retire. That would allow them to avoid the tax consequences of taking withdrawals on top of their earned income.
What are Alternative Options?
Since non-spouses are unable to roll over an inherited IRA from one account to another with a different owner, the only option is to take distributions. In many cases, the new 10-year rule under the SECURE Act means harsh tax consequences, but benefactors may take a different approach. Rather than leave their IRA as an inheritance, individuals may fund a life insurance policy and list the heir as beneficiary. Since the benefactor pays taxes on the insurance premiums, the death benefit provided to the beneficiary is tax-free.
We recommend you familiarize yourself with all the rule changes associated with the SECURE Act. If you have clients who are affected and looking to know more about their options, help them formulate a plan that is ideal for their specific financial situation. Click here to read the SECURE Act legislation in full.