In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act made significant changes to the rules for retirement accounts.
The most notable change removed the “stretch” provision for certain beneficiaries of inherited retirement accounts, replacing it with a 10-year rule. Whereas the stretch provision allowed beneficiaries to make distributions from an inherited account over multiple decades, the new provision requires that they entirely deplete the account within 10 years after the original owner’s death.
While changing this clause makes it more difficult to minimize income taxes, fortunately, there are still strategies to help.
Let It Ride
One strategy is to leave the inherited funds in the retirement account for as long as possible. Since the SECURE Act allows for distributions at any time and amount (as long as the account is depleted by the end of the 10th year), the beneficiary could hold off on withdrawals during the first nine years. Then in the 10th and final year, they could distribute all the funds in the account.
This strategy preserves the tax-deferred status of the inherited account for as long as possible, though it may not be advisable if the final distribution pushes the beneficiary into a higher tax bracket.
Here are three scenarios where delaying distributions makes sense:
- When the inherited account is a Roth IRA. The longer a Roth beneficiary leaves the money in the inherited Roth account, the longer the funds can continue to grow tax-free.
- When the beneficiary is already in the highest tax bracket (currently 37%). In this case, the final distribution can’t push the beneficiary into a higher bracket, and few taxpayers benefit more from the power of tax-deferred growth than those in the highest bracket.
- When the balance in the account is small. Someone inheriting a lower balance may be unlikely to reach a higher tax bracket, even after 10 years of growth.
Spread It Out
Another strategy is to spread out the account income over as many years as possible.
Since the 10-year rule begins in the calendar year following the year of the account owner’s death, some beneficiaries might have the option to extend distributions over as many as 11 tax years.
If death occurs early in the calendar year, a beneficiary could have enough time to establish an inherited IRA and take a distribution from the account before the end of the year. This first distribution would occur in “year 0” of the 10 years, allowing the beneficiary to spread the income from the inherited account over 11 tax years. This approach doesn’t come close to the multi-decade timeframe of the stretch provision, but it can still help minimize taxes.
Time The Distributions
While spreading out distributions can be an effective strategy for beneficiaries with stable income, yet another strategy benefits those anticipating income swings. These beneficiaries can make distributions during the years other income is lower.
Here are a few scenarios where lumping taxable distributions from inherited accounts might make sense:
- The beneficiary, or their spouse, will be retiring
- A child will be applying for student aid
- A significant charitable gift is planned
- The beneficiary intends to marry and can benefit from the lower tax rate of their married-filing-jointly bracket
- The beneficiary will reach age 70 ½, becoming eligible to make qualified charitable distributions from the account
While the 10-year rule is one of the biggest impacts of the SECURE Act, these strategies can help minimize income taxes. Designing a distribution plan that captures income in the most tax-efficient years is the best defense for beneficiaries subject to the new rule.
Rick’s Insights
- The SECURE Act of 2019 removed the stretch provision for beneficiaries of inherited retirement accounts and replaced it with a 10-year rule.
- Under the 10-year rule, distributions may be taken at any time and amount, but all money must be distributed by the end of the 10th year.
- The first distribution can occur in “year 0,” allowing some beneficiaries to spread income out over 11 tax years.
