In our previous newsletter, we looked at how the 2019 SECURE Act changed the rules for heirs of retirement accounts—specifically, how a new clause requires that a beneficiary deplete their inherited account within 10 years after the original owner’s death (as opposed to over multiple decades).
Compressing the distribution schedule to just 10 years has the potential to force dollars out of the inherited retirement account at a higher tax rate.
Here, we will consider a few more strategies for minimizing this negative impact—and maximizing the after-tax value passed to heirs.
Add Beneficiaries to the Account
Under the new rule, an account owner can’t spread the distribution of funds over more than 10 years, but they can distribute the funds to more beneficiaries. Naming children and grandchildren as primary beneficiaries (if they are adults filing their own tax returns) may help minimize the cumulative impact of income taxes.
Account owners following this strategy should be aware that pre-tax distributions to young beneficiaries are treated as unearned income and may be subject to the Kiddie Tax (equivalent to the parent’s marginal tax rate). In this case, the benefits of adding a grandchild as a beneficiary may be lost if the child is very young.
Weigh Beneficiaries by Tax Bracket
Generally, distributions from inherited Roth accounts will be tax-free to beneficiaries, regardless of their tax situation. This is not the case for pre-tax retirement accounts left to beneficiaries in different tax brackets. A higher income tax rate equals a lower after-tax value relative to heirs in a lower tax bracket.
While splitting assets equally among children may sound like an equitable strategy, it could leave heirs with very different after-tax values. Considering after-tax values among heirs when distributing pre-tax, after-tax, and tax-free accounts like Roth IRAs could lead to more tax-efficient distributions.
Bypass A Spouse
For married couples, another strategy is to pass some (or all) of pre-tax retirement accounts belonging to the spouse who dies first directly to beneficiaries. The portion of the account that skips the surviving spouse will start the 10-year clock to deplete the account. When the second spouse dies, a second 10-year clock will begin to deplete the second account inherited from the surviving spouse. This means a couple could potentially give their beneficiaries as many as 20 years to spread out distributions.
Consider a Roth Conversion
A straightforward strategy for minimizing taxes to beneficiaries is to convert pre-tax retirement accounts to Roth IRAs. This approach makes sense in situations where the tax rate paid on the converted amount would be less than the tax rate paid by the beneficiary. These conversions can be done over time to spread out and minimize income taxes for the account owner.
The key objective is to get distributions out of pre-tax accounts at the lowest possible tax rate. Distributions can still be spread over the lifetime of the owner, even though they can no longer be spread over the lifetime of the beneficiary.
When deciding how to respond to the new 10-year rule, the first step is to review all beneficiaries and determine how they might be impacted by the rule. See if any of the strategies we have outlined here apply to your situation. While the best decision may be to do nothing, in some cases these approaches are more effective than simply spreading the dollars out across the allotted 10 years.
- Young beneficiaries may become subject to the Kiddie Tax from pre-tax distributions made from an inherited retirement account.
- A beneficiary’s higher income tax rate equals a lower after-tax value relative to heirs in a lower tax bracket.
- Distributions can still be spread over the lifetime of the account owner, but they can no longer be spread over the lifetime of the beneficiary.