How a New 10-Year Rule Could Affect Your Inherited IRA

Spouses, parents and grandparents often want to leave a financial legacy for their loved ones after they are gone. This can come in several forms, such as leaving real estate, a business or assets in a retirement account to a family member or friend. An inherited IRA is another option.

When someone dies, they may leave an IRA to either their spouse, a family member or another individual they choose. However, the rules for when to take a required minimum distribution (RMD) — the minimum amount of money you need to withdraw from an inherited IRA each year — are different for spousal and non-spousal beneficiaries. Recent changes to federal law also affect how you can handle the money in this account. Here's what to consider.

Changes That May Affect Your Inherited IRA

The SECURE Act, which stands for Setting Every Community Up for Retirement Enhancement, went into effect on January 1, 2020.¹ It comes with several changes for inherited IRAs. First, if an IRA account holder dies on or after January 1, 2020, and you inherit their IRA, you'll now generally have 10 years after the account holder's death to withdraw all the money. Otherwise, you'll face a 50% penalty on any money remaining in the account. However, this rule doesn't apply to the account holder's spouse, children who are minors (a special rule applies once a minor reaches the age of majority), beneficiaries who are disabled or chronically ill and beneficiaries who are within 10 years of the age of the original account holder.

Before the SECURE Act, beneficiaries who weren't in these categories could just withdraw all the money in the IRA within five years of the account holder's death or take the RMD each year. The second option meant a younger beneficiary could stretch out IRA distributions for decades and allow the remaining money in the IRA to grow without paying taxes on it until they withdrew it from the account. With the new law, these beneficiaries, unless an exception applies, will now have to withdraw all the money from the account within 10 years. This could lead to higher taxes if someone is in a higher tax bracket when they take a distribution from the IRA.

Considerations When Navigating Changes to Inherited IRAs

If you plan to pass on an IRA to a loved one or are in a position to inherit one, here are some things to consider to help make matters easier down the road.

If the Money Is in a Trust

In some cases, an inherited IRA may be kept in a trust. This can complicate things for younger beneficiaries who may not have access to the trust until they're a certain age or may only be allowed to withdraw a certain amount of money each year. If you plan to have a trust listed as the beneficiary of your IRA, you may want to adapt your planning to factor these recent changes.

For example, you could structure your IRA so that funds from the account are evenly distributed over each of the 10 years. This way, your beneficiaries wouldn't have to withdraw all the money at one time, which may result in a larger tax bill. You also could consider using a different type of trust, such as an accumulation or discretionary trust, that may offer more flexibility to either distribute or retain funds within the account. However, this will come with certain tax consequences, so it may be helpful to talk to an estate planning attorney to determine an appropriate strategy for your needs.

Spreading Out Distributions

Because of the new 10-year rule, there are no longer any RMD requirements for non-spousal beneficiaries who do not fall into one of the exceptions. However, if you inherit an IRA in the coming years, and you do not meet one of the exceptions to the 10-year rule, you could take equal distributions to help spread out your tax liability over the 10 years. You also could take larger distributions during the years your income is lower. Because a lower income could lower your tax bracket, you may not have as big a tax bill. Again, the right option for you will depend on your unique situation. Consider speaking with a tax professional for more information.

Annuities

Another option is to convert the assets in the IRA into an annuity. An annuity could help defer taxes, offer growth potential, and help set up an income stream that meets the 10-year requirement.

If you're the original IRA account holder and have already converted your IRA into an annuity, you can pass this on to your beneficiaries. If you've already started to receive payments from the annuity, the insurance company may give your beneficiaries a refund of the unpaid premium after your death — depending on your policy.

Roth Conversions

If you have a traditional IRA, you could also convert it to a Roth IRA and pay the taxes on the conversion. If certain qualifications are met, this may allow your beneficiaries to withdraw distributions over 10 years without having to pay taxes. However, this approach may come with certain fees and tax consequences, so consider talking to financial professional or tax expert before you make a decision.

Managing an Inherited IRA for the Future

Leaving loved ones a financial legacy can be very important for many parents, spouses and grandparents. Whether you intend to pass on an IRA or expect to inherit one, it can be helpful to understand how the new 10-year rule may affect you. Consider talking to the right financial professionals as you navigate these changes.

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Sources

1. H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019. https://www.congress.gov/bill/116th-congress/house-bill/1994.