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Robert Bloink and William H. Byrnes

Retirement Planning > Spending in Retirement > Required Minimum Distributions

Can You Avoid the 5-Year Inherited IRA Distribution Trap?

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What You Need to Know

  • Almost every non-spouse beneficiary who inherits a traditional IRA now must empty the account within 10 years.
  • But the five-year rule still applies to some beneficiaries.
  • Clients should keep their beneficiary designations updated to help prevent problems for heirs.

By this point, most clients understand that the Secure Act fundamentally changed the game when it comes to taking distributions from inherited retirement accounts. Still, it’s possible that some clients won’t know which distribution period applies when they actually do inherit an account. 

Even more, it’s also possible that the client may not understand that there continue to be situations where the old “five-year rule” may apply — and require the account to be emptied within five years of death. These clients could take a serious tax hit, especially if the old five-year rule does apply to their account. With proper planning, however, it may be possible to maximize the value of the limited post-Secure Act stretch IRA by avoiding the five-year rule.

Which Distribution Period Applies?

Prior to the Secure Act, designated beneficiaries could opt to empty an inherited retirement account using their own life expectancy or within five years of the original owner’s death (the “five-year rule”).

For non-spouse beneficiaries of clients who died after Dec. 31, 2019, the “stretch” inherited retirement account strategy has been sharply limited. Under the Secure Act rule, almost every non-spouse beneficiary who inherits a traditional 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 distributions. 

The IRS’ proposed regulations would require these designated beneficiaries to take annual RMDs within the 10-year distribution period if the original account owner died on or after the required beginning date. In other words, the beneficiary can’t always simply wait until year 10 to empty the entire account. 

For tax years beginning in 2020 and thereafter, only eligible designated beneficiaries can 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 10-year distribution period applies), (3) disabled beneficiaries, (4) chronically ill beneficiaries and (5) beneficiaries who are less than 10 years younger than the account owner.

The Five-Year Payout Rule

While most IRA beneficiaries will be subject to the new 10-year distribution rule post-Secure Act, there are situations where the old five-year rule can continue to apply.

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.

Under current law, if the client lists their estate as their IRA beneficiary, the account will be subject to the five-year distribution rule. In other words, if an individual is listed as the beneficiary of the IRA owner’s estate, that individual will be required to empty the inherited IRA within the five-year time frame. It doesn’t matter that the person was a designated beneficiary of the estate.

It’s also possible that the terms of the IRA itself may require the account to be emptied within five years after the original account owner’s death. If the plan document provides for distributions to be made under the five-year rule only if the original account owner died before their required beginning date, the beneficiary cannot keep the funds within the inherited account and stretch distributions over the life expectancy distribution method even if they otherwise qualify as an eligible designated beneficiary.

In these cases, it is the IRA document itself that would leave the client facing the old five-year distribution period.

Conclusion

Most clients would prefer to maximize the tax deferral benefits of an inherited account — meaning that it’s important to revisit their beneficiary designations to make the most of the post-Secure Act stretch IRA rules.

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