Making the Most of the SECURE Act’s New 10-Year Rule
An IRA can be a wonderful account to inherit, but the rules have changed recently, and it is important to understand what your options are when you inherit this type of account. This article will only address strategies for adult children who are named as beneficiaries on their parent’s IRA accounts, referred to as non-eligible designated beneficiaries. There are different rules for eligible designated beneficiaries1 and non-designated beneficiaries,2 and if you fall into one of those camps, you should consult with your financial adviser to better understand your distribution options.
The Death of the Stretch IRA
Before getting into some strategies on what to do, it is important to understand the background behind these recent rule changes. Prior to January 1, 2020, if you inherited an IRA from your parents, you were able to keep that account open for the rest of your life (and maintain the tax benefits) as long as you took a required distribution every year. The required distribution was calculated using an IRS formula and was generally only a fraction of the total account value. This allowed owners of these accounts to “stretch” these distributions out over the course of their life expectancy and receive significant tax advantages by deferring income taxes. However, all this changed with the passage of the SECURE Act in 2019. For those beneficiaries who inherited an IRA after December 31, 2019, the rules are different.
The New 10-Year Rule
The new rule for adults who inherit an IRA from their parents in 2020 and beyond is that they must liquidate that account within 10 years. The 10-year clock starts ticking the year after the death of the original owner. For example, if John’s mother passed away in 9/1/2020, the first year for calculating 10-year period would be 2021. Therefore, John would have to totally liquidate the account by the end of the tenth year—in this case, 12/31/2030.
This may not seem like a big deal at first, but consider what would happen if John inherited an IRA worth $500,000 and did nothing for 10 years. Assuming investment growth of 7%, that account would almost double in that time and be close to $1,000,000. And at the end of the tenth year, the entire balance of the IRA would need to be distributed and included in taxable income for 2030. This would likely push John into the highest income tax bracket for that year, and he could easily end up paying 50% or more of this total amount in state and federal taxes. Better planning should be done to avoid this.
Three Strategies to Mitigate the Impact of the 10-Year Rule
- Maximize available tax-deferred accounts and use inherited IRA for cash flow.
Let’s assume that both John and his wife, Mary, have access to 401(k) plans at work and are over 50 years old. They have the ability to put in a combined total of $52,000 into their 401k accounts—but previously, they have been unable to afford putting in the full amount. However, now that they have received this inheritance, they should contribute the full $52,000 into their 401(k) plans and take distributions from the inherited IRA to make up any cash flow needs. This essentially allows them to move money from the inherited IRA (which has a 10-year time limit) to their own retirement accounts where there is a longer time frame for them to take out distributions.
- Move high-growth assets out of the inherited IRA.
Let’s also assume that John and Mary’s portfolio has a target allocation of 70% stocks and 30% bonds. They should move as much of the 30% fixed allocation to the beneficiary IRA, since the growth on fixed income will likely be lower than equity over a 10-year period. This will shift the higher growth assets to accounts that do not need to be liquidated in 10 years—reducing the potential for higher taxes when the inherited IRA must be emptied at the end of the 10-year period.
- Take advantage of low-income years.
Over the next 10 years, John and Mary should come up with a plan to increase distributions out of the beneficiary IRA during low-income years. This will help ensure that the distributions from the IRA will be taxed at lower rates. For example, Mary’s business may have a bad year, causing their joint income to be lower than normal. This would be a great year for them to take a little more out of the inherited IRA, as it will be taxed at a lower rate. John and Mary could also consider retiring a year or two earlier than planned and living off the inherited IRA. This would allow them to spend down the inherited IRA in a very low tax bracket while allowing their other retirement accounts and Social Security to continue to grow.
In summary, the new rules regarding inherited IRAs can cause significant tax issues if proper planning is not done. If you inherit an IRA from your parents, make sure you understand these rules so that you do not end up paying more of your inheritance to Uncle Sam than you need to.
- Eligible Designated Beneficiaries include surviving spouses, certain minor children, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the decedent.
- Non-designated beneficiaries generally include nonperson entities such as estates, charitable organizations, and trusts.