The Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in late 2019, providing many different ways to help Americans save for retirement. But, one not-so-helpful provision is the elimination of the stretch IRA for non-spousal beneficiaries. If you expect to inherit an IRA from your parents or another person who is not your spouse, you can also expect a change in the way you must take distributions from that account. Below is what you need to know to understand how the SECURE Act impacts inherited IRAs.
How Inherited IRAs Worked before the SECURE Act
In the past, if you inherited an IRA from anyone, you were able to calculate and stretch the required minimum distributions (RMDs) from the account based on your own life span. These accounts were appropriately called stretch IRAs. The yearly distributions were included in your annual income, and you were taxed accordingly. Of course, you might have been bumped into a higher bracket—but the ability to spread it out over many years made it beneficial.
But the SECURE Act eliminated the ability to stretch those distributions over your own life span.
Here’s How the SECURE Act Impacts Inherited IRAs
Beginning in 2020, if you inherit a non-spousal IRA, you have only 10 years to take those distributions. Let that sink in for a minute. Because now, not only will the distributions be greater within that 10-year period, your tax liability will skyrocket, too.
The government wants their money, which has been growing on a tax-sheltered basis since the original IRA was opened by your benefactor—and this is how they’re going to get it.
Those who will feel the biggest impact are people who inherit large net worth accounts. For example, let’s say your parents or grandparents included IRAs as an estate-planning tool to leave you a large portion of their wealth. Depending on your age at their time of death, in the past you may have had a good 50 years or more to take your RMDs from the account. And, of course, the income tax implications were also spread out as you withdrew funds each year. But now, with only 10 years to withdraw those funds, expect your yearly income and subsequent tax liability to be quite substantial if the inherited IRA does indeed have a large balance.
The New Law Does Offer Withdrawal Options
Now, there are no restrictions on how you can take those RMDs. You are not required to take a distribution every year.
As long as the account is depleted before that 10th year deadline, the SECURE Act allows you to:
- Spread the distributions out equally over 10 years
- Take random withdrawals every few years
- Wait until the 10th year to take the money out in one lump sum
The way you withdraw the funds depends on your personal financial situation and deserves some strategic planning with your financial advisor.
You’ll be taxed on the RMD distribution at your ordinary income rate. So, if you start taking distributions during your top earning years, expect your income tax burden to be high. If your income is fairly low to begin with, that hit might not be so great. If you are close to retiring, talk to your advisor about delaying those inherited IRA distributions until you do retire. As long as you take them within the 10-year limit, if you take them after you retire—you avoid having to combine it with earned income.
Also, Certain People Are Exempt from the 10-Year Rule
Individuals who are exempt from the 10-year rule:
- Spouses who inherit their deceased husbands’ or wives’ IRAs
- Minor children, excluding grandchildren, are exempt until they come of age—at which time they have 10 years to distribute all funds
- Beneficiaries with disabilities as defined by the IRS
- Individuals who have chronic illnesses as defined by the IRS
- Beneficiaries who are not more than 10 years younger than the original account owner when he/she passes away (i.e., a brother or sister)
Stretch IRAs Inherited before 2020
The new ruling does not affect these accounts. As long as you inherited the IRA before January 1, 2020, you’re able to continue taking RMDs based on your own life expectancy.
How the 10-Year Rule for Inherited IRAs Changes Estate Planning
If you have a trust that is named as the beneficiary of your IRA, those structures are impacted by the SECURE Act’s 10-year rule, too. Trusts can be complex—so we advise you to consult your financial professional to ensure your trust is structured properly and compliant with SECURE Act provisions.
The good news for inherited Roth IRAs is that distributions are typically tax free. However, the caveat is that they are still bound by the 10-year rule. So, beneficiaries must still withdraw all funds within that 10-year period, but they have the potential to avoid being taxed on those distributions.
With this in mind, if you have an IRA you were planning to pass on to your children or grandchildren, you might consider a Roth conversion. Discuss this option with your financial advisor first—because the amount you convert is taxed as ordinary income. Depending on your situation, retirement income tax-bracket, and other factors, it may make smart financial sense for you to perform a conversion to provide for your heirs as you desire when you’re gone.
There are a few other estate planning alternatives to consider. Life insurance policies may be a good choice instead of IRAs to pass your wealth on to loved ones. You’ll pay tax on the premiums, but your beneficiaries won’t pay tax on the benefits when you pass. Irrevocable living trusts and charitable remainder trusts are also options depending on your intentions. Your financial advisor is the best person to help you determine what changes you should make moving forward.
This article was written for informational purposes only and should not be considered as tax, legal, or financial advice. Please seek appropriate counsel to learn more about how the elements of the SECURE Act affect you and to determine any changes to your current estate plan.