CHANGES TO INHERITED IRA DISTRIBUTIONS

IMPACT OF THE SECURE ACT

The Setting Every Community Up for Retirement (SECURE) Act applied several new provisions to the way IRA distributions are handled, including the age at which required minimum distributions (RMDs) begin for some original owner-held retirement accounts. Another, and arguably even more consequential, measure has altered the way in which non-spousal inherited IRAs and 401(k)s are distributed. In short, for IRAs inherited in or after 2020, RMDs have ended and the stretch IRA is no longer an option.

YOU HAVE TO FULLY WITHDRAW AN INHERITED IRA WITHIN 10 YEARS

Non-spousal beneficiaries of IRAs prior to 2020 were required to take RMDs each year based on a life expectancy table calculated by the IRS. This is called a stretch IRA—essentially, as a beneficiary, you were able to stretch the distributions out over the course of your own lifetime.

The passage of the SECURE Act removed the stretch provision for IRAs inherited after 2020 (note that IRAs inherited before January 1, 2020, are not subject to the new rules). In most cases moving forward, non-spousal beneficiaries now have ten years to fully withdraw the IRA assets. Yearly distributions are no longer required as long as the entire account is fully distributed by the end of the tenth year. If you have an IRA, the new rules apply to your account and your non-spouse heirs.

NEW PROVISION, NEW PLANNING NEEDS

As with anything, there are pros and cons to the new rule. One nice thing is that it allows some beneficiaries to balance their inherited IRA distributions with their other income, potentially diminishing the tax impact. For example, a son who inherits his mother’s IRA after 2020 works full time, but he plans to retire in three years. He might defer taking distributions until retirement when his income is lower and his tax burden is minimized. As long as the account is fully distributed by the end of the tenth year, he will face no penalties for not taking a distribution in any given year.

On the other hand, the new ten-year rule can cause a tax headache. The old RMD rule calculated the distribution based on the beneficiary’s life expectancy, which frequently allowed for a longer timeline than ten years. Now, however, the ten-year rule condenses the distributions into a shorter time frame, potentially accelerating the tax burden. And if beneficiaries wait until the final year to take the full amount, they could face a large tax bill.

Another impacted area regards trusts. Under the old rule, a popular strategy to control the timing of distributions to heirs was to make a trust the beneficiary. The SECURE Act has now changed the way trusts are treated as beneficiaries, and it could mean the IRA money will have to be distributed to heirs within a time frame that no longer aligns with the wishes of the trust’s grantor(s). Be sure to consult with an attorney if you have designated or are thinking of designating a trust as your IRA beneficiary.

AM I EXEMPT?

The new rule allows exceptions for two types of beneficiaries, permitting those who qualify to continue using the stretch. The first type is an eligible designated beneficiary (EDB). There are five EDBs:

• Surviving spouse: If you are the surviving spouse, you can roll the IRA into your own and wait to take RMDs until you reach age 72. Your RMD will be calculated based on your life expectancy.

• Minor children of the decedent: If you are a child of the decedent younger than 18, you must take distributions based on your own life expectancy. As soon as you reach 18 (or up to age 26 with an education extension), however, the assets must be distributed within ten years. Note that this exception does not apply to any other minor beneficiary, such as grandchildren.

• Chronically ill individual: If you meet the definition of Code Section 7702B(c)(2)  (certified by a licensed health care practitioner as being unable to perform at least two activities of daily living for at least 90 days or requiring substantial supervision to protect from threats to health and safety due to severe cognitive impairment), you are able to take distributions calculated on your own life expectancy.

• Disabled individual: If you meet the definition as provided by IRC Section 72(m)(7) (unable to engage in any substantial gainful activity due to medically determinable physical or mental impairment which can be expected to result in death or be of long-continued, indefinite duration), you are able to take distributions calculated on your life expectancy.

• Individual not more than 10 years younger than the decedent: No matter the relationship to the decedent (partner, sibling, friend), if you are fewer than ten years younger than the decedent, you are able to take distributions calculated on your own life expectancy.

The second exception is, as noted above if you inherited an IRA or 401(k) prior to 2020. In this case, the new rules do not apply to you. You will still be required to take out minimum distributions each year based on your life expectancy as calculated by the IRS, but your distribution schedule is not based on a flat ten years.

Reviewing and updating your beneficiaries is an important practice, and with the passage of the SECURE Act, there is even a greater reason to ensure the assets in your account are set up to be distributed as you want. If you think you need to reassess your beneficiaries, it’s time to talk to Day Hagan.

Sincerely,

Natalie Brown, CFP®
Director of Client Services
Day Hagan Private Wealth

—Written 09.16.2020.

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