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Avoiding an Inherited IRA Tax Time Bomb Under the Secure Act

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Big changes for inherited IRAs came about in 2019. Despite this, the COVID-19 pandemic struck the U.S. mere months after the Setting Every Community Up for Retirement Enhancement Act was signed into law — meaning that for many clients, planning for the significant changes made by the Secure Act may have fallen through the cracks as they struggled to handle the disruptions brought about by the pandemic.

Now, as the dust has begun to settle and hopes for vaccine effectiveness are on the rise, it’s time to revisit changes made to the tax treatment of inherited IRAs. These new rules remain important for clients who anticipate inheriting or leaving an IRA behind — and for those with substantial inherited IRA balances, planning for the changes can be critical to minimizing future tax headaches.

RMD Changes for Inherited IRAs Under the Secure Act 

For clients who pass away after Dec. 31, 2019, the “stretch” inherited IRA strategy has been sharply limited. Under the Secure Act rule, almost every client who inherits a retirement account (IRAs, 401(k)s, etc.) in 2020 and beyond will have to empty the account within 10 years— and pay income tax on the distribution. 

Generally speaking, if the IRA beneficiary is not an “eligible designated beneficiary,” the entire account must be emptied within 10 years. Eligible designated beneficiaries (EDBs) include spouses, disabled and chronically ill beneficiaries, minor children of the account owner and beneficiaries who are less than 10 years younger than the owner.

EDBs are exempt from the new rules—and can continue to empty the inherited account by taking distributions over their own life expectancy (and can stretch the tax liability over that time period).

However, there are exceptions to the exception. While a surviving spouse can roll the IRA into an IRA in his or her own name — and simply treat it as though it were the surviving spouse’s own account — minor children become subject to the 10-year rule once they reach the age of majority (usually, age 18). Once minor children reach age 18, they have until age 28 to empty the account.

Beneficiaries who are subject to the 10-year rule are not required to take a distribution every year (i.e., the beneficiary can still defer taxes for 10 years and take a lump sum distribution at the end of that period). However, without proper planning, the tax consequences can be serious. 

RMDs for Beneficiaries Exempt From the 10-Year Rule

Even IRA beneficiaries who are exempt from the 10-year rule may be required to take an initial RMD from the account soon after inheriting it. 

If the original account owner had already begun taking RMDs, the beneficiary is required to stick to that RMD schedule until the end of the first calendar year — or risk being stuck with a 50% penalty on the amount the beneficiary was supposed to take. In other words, inherited IRA beneficiaries are required to take the original owner’s final RMD in the year of death.

Planning to Avoid Tax Traps

For many clients, the smart move may be to gradually empty the inherited IRA over the 10-year period to avoid a substantial tax bill in year 10. However, beneficiaries should examine their own tax picture. If a beneficiary anticipates a lower-income year during the 10-year period, it could be smart to take a larger distribution in that year to take advantage of a lower income tax rate.

Where there are multiple beneficiaries, splitting the account into multiple accounts — each with a separate beneficiary — can also be helpful in minimizing taxes (especially if one beneficiary qualifies as an EDB). In these cases, each beneficiary can then withdraw funds according to their own tax situation.

Of course, the most beneficial tax moves are often those available before the original account owner’s death. Converting portions of a large IRA balance to a Roth account incrementally over time might help some clients minimize the tax hit that beneficiaries could face during the 10-year window — and those clients might want to consider acting quickly if they anticipate rising tax rates under the Biden administration.

Trust structures can also be valuable for clients who want to make sure beneficiaries don’t liquidate the IRA funds too quickly.

Conclusion

Inheriting an IRA has never been quite so complex — especially if the client wishes to leave the account to multiple people. Clients who have inherited an IRA recently should be advised of the new rules to avoid a tax hit 10 years down the road — and for clients who anticipate leaving large IRA balances, the time to start planning is now.

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