Advisers are dealing with significant changes and a range of client situations as a result of the Setting Every Community Up for Retirement Enhancement Act of 2019, better known as the SECURE Act.
One of the biggest impacts of the SECURE Act is upon the changes in the distribution rules for inherited IRAs.
Goodbye to the Stretch IRA
For IRAs inherited on or before Dec. 31, 2019, non-spousal beneficiaries could take RMDs based on their own life expectancy -- which often provided a longer period of time to stretch out the tax-deferred nature of the account. They could also name their own account beneficiaries, potentially further stretching the tax-deferral benefits.
Under the new rules, with some exceptions, most non-spousal beneficiaries are now required to fully take distributions for the IRA account within 10 years. This shorter time period to empty the account can result in some significant unplanned for tax bills for these beneficiaries, especially for those who might be in their peak earning years. Additionally, these new rules may serve to disrupt the plans of many IRA account owners to distribute their retirement savings -- often a significant percentage of their wealth for many -- to their heirs.
New Inherited IRA Rules for Beneficiaries
Under the rules of the SECURE Act there are two classifications of designated beneficiaries for an IRA.
Eligible designated beneficiaries can still inherit the IRA and take RMDs over their lifetime as before. They are:
- Spouses who can inherit the IRA and treat it as their own
- Minor children of the account owner
- Disabled beneficiaries
- A chronically ill beneficiary
- A beneficiary who is not more than 10 years younger than the account owner.
For all other non-spousal designated beneficiaries, the new 10-year distribution period applies.
Name Your Spouse as Beneficiary
In an article for Kiplinger’s, financial adviser Rhian Horgan suggests that IRA account holders who had planned on leaving their traditional IRA account to children or grandchildren who aren’t minors instead name their spouse as the beneficiary of the account.
This allows their surviving spouse to continue to invest the account on a tax-deferred basis for their lifetime as if the account was their own. While they will still be required to take their normal RMDs on the account, the tax consequences of this distributions will likely be less than the tax hit the non-spouse beneficiaries would experience under the new inherited IRA rules.
Horgan suggests two strategies to use the proceeds from the RMDs to benefit heirs:
Use the funds to make lifetime gifts to them, and/or establish an investment account funded with these proceeds for them that would receive a step-up in basis upon the surviving spouse’s death
Consider a Roth Conversion
Horgan also suggests that the original IRA account holder consider converting some or all of their traditional IRA account to a Roth IRA. There are pros and cons to this.
On the pro side, Roth IRAs have no RMD requirements for the account holder and can be left to a spousal beneficiary with the same rules in place. For non-spousal beneficiaries, the account must still be distributed within 10 years under the SECURE Act, but those distributions are tax-free. Conceivably the beneficiary could let the funds grow for the full 10 years and then take the full amount in the account as a distribution in year 10.
The potential con of this strategy involves paying taxes on the Roth conversion for the account holder. Depending on their situation and their income, this could result in a major tax hit if done during their peak income years. This could also have a negative impact on their own retirement. They will need to weigh this factor along with the probable tax rate of their beneficiaries when they are likely to inherit the account.
Stretching an IRA for Married Couples
Jim Blankenship recently suggested a technique on his blog, Financial Ducks in a Row, for married couples to potentially stretch their IRAs for designated non-spousal, non-eligible beneficiaries to make the most of the 10-year distribution.
Under this scenario, if each spouse names the same group of beneficiaries, let’s say their adult children, as primary or contingent beneficiaries, this group of beneficiaries will get two separate 10-year windows in which to take their distributions and pay taxes on those distributions.
This strategy is dependent on the ability of the surviving spouse after the death of the first spouse to be able to support him or herself without some or all of the funds from the first spouse’s IRA. Even if the surviving spouse is named as beneficiary, they can decide to disclaim some or all of this distribution and have the money then revert to the contingent beneficiaries, their children in this case.
The SECURE Act has added some new planning wrinkles in several cases, including the distribution of traditional IRA assets to non-spousal beneficiaries. Clients will be counting on their financial advisers for innovative solutions here.