As is common knowledge by now, the Secure Act limited the “stretch” tax deferral benefits of inherited IRAs to 10 years for most non-spouse beneficiaries beginning in 2020. Although there are no RMD requirements during the 10-year period, the potential for a substantial tax hit in year 10 means that current IRA account owners should revisit their beneficiary designations now.
The value of making any changes will, of course, depend upon who is currently designated as the account beneficiary. Understanding which beneficiaries qualify as “eligible designated beneficiaries” under the new rules is step one. To fully understand how the new rules will impact the value of an IRA after death, a deeper dive into the considerations for the various classes of current designated beneficiaries is needed.
Eligible Designated Beneficiaries: Background
Eligible designated beneficiaries may continue to use their life expectancy to determine inherited IRA distributions (subject to some special rules). Generally, eligible designated beneficiaries include: (1) surviving spouses, (2) minor children of the account owner (although the life expectancy rule applies only until the child reaches the age of majority, at which point the ten-year elimination period applies), (3) disabled beneficiaries, (4) chronically ill beneficiaries and (5) beneficiaries who are less than 10 years younger than the account owner.
Non-designated beneficiaries generally continue to be subject to the five-year payout rule even post-Secure Act (examples of non-designated beneficiaries include the account owner’s estate or someone who inherits the account but was not specified in the relevant forms as the designated beneficiary).
If the IRA designated beneficiary is currently the spouse of the account owner, no major changes need to be made. After death, the surviving spouse’s right to roll the IRA into his or her own IRA continues to exist and if the spouse fails to do so, the spouse’s own life expectancy can be used to determine distributions from the deceased spouse’s IRA under the old rules.
Non-spouse Individual Beneficiaries Post-Secure Act
If a child, grandchild or even a sibling of the account owner is named beneficiary, the situation becomes much more complex. Only children of the account owner qualify as eligible designated beneficiaries if they are minors when they inherit the account. Even so, minor children of the account owner do not get the full benefit of the life expectancy stretch that existed pre-Secure Act. Once the child reaches the age of majority, the life expectancy rule goes away and the same ten-year window begins to run.
Account owners who have named young grandchildren or family members as designated beneficiaries solely because of the tax benefits should reevaluate, as well. In some cases, continuing to name someone young as beneficiary can remain beneficial from a tax standpoint. If it reasonable to expect that the grandchild will be in a low tax bracket upon inheriting the account, the ability to withdraw funds and have them taxed at a low ordinary income tax rate can be beneficial (a 22-year old grandchild will likely be in a much lower tax bracket than a 50-year old child). However, with respect to minors, it’s important to remember the kiddie tax rules that pull unearned income into the parents’ tax bracket.