Inherited Retirement Plan from 2019? Take Immediate Action to Preserve Life Expectancy Rule

by Prof. Robert Bloink and Prof. William H. Byrnes

Clients who inherited employer-sponsored retirement plans in 2019 may have one final opportunity to stretch required distributions from the account over their life expectancy. Prior to 2020, beneficiaries of inherited accounts had two primary options for receiving account distributions: the five-year rule and the life expectancy rule. The SECURE Act sharply limited the availability of the “stretch” option under the life expectancy rule. However, certain clients may have a limited window of time to override application of the five-year rule and take advantage of the old life expectancy rule. Now is the time to carefully evaluate these options for clients who inherited 401(k)s, 403(b) plans or governmental 457(b) plans in 2019—or risk missing out on a valuable tax deferral strategy.

Background on Inherited Retirement Account Distributions

For non-spouse beneficiaries of clients who died after December 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 distribution.

Under prior law, non-spouse beneficiaries could elect to apply the five-year rule and empty the account within five years (for accounts inherited in 2019, by December 31, 2025). If the original account owner died before his or her required beginning date, however, they could choose to apply the life expectancy rule and take distributions over the beneficiary’s lifetime—stretching the tax liability over that longer time period to maximize the tax deferral benefits of the retirement account.

When it comes to qualified plans, the plan document often specifies which option is available. In many cases, the plan document defaults to the five-year option—meaning that beneficiaries could only take advantage of the more valuable life expectancy rule if they take specific action to elect that treatment.

2019 Inherited Accounts: Act Now

Typically, the beneficiary’s status as a “designated beneficiary” for an account inherited in 2019 would have been determined as of September 30, 2020. The designated beneficiary would have been required to elect the life expectancy distribution method by December 31, 2020 under normal circumstances.

Because of the COVID-19 pandemic, that deadline was postponed to December 31, 2021. If the plan permits the designated beneficiary to choose between the five-year rule and the life expectancy rule, the beneficiary must make that election by December 31.

However, there are situations where the plan document only provides for distributions to be made under the five-year rule if the original account owner died before his or her required beginning date. That means the beneficiary cannot keep the funds within the inherited account and stretch distributions over the life expectancy distribution method.

Even if the original account does not provide for the life expectancy distribution option, the beneficiary may be able to override this limit. To do so, the beneficiary must roll the inherited funds into a beneficiary inherited IRA before the December 31, 2021 deadline. The rollover must be accomplished in a direct trustee-to-trustee transfer (in other words, the beneficiary cannot merely take a distribution and re-deposit the amounts into an IRA).

A client who rolls inherited funds into an IRA should exercise caution in ensuring that the IRA is properly titled (by the financial institution) as an inherited IRA. This means that the original account owner’s name should appear in the IRA title, along with the beneficiary’s name. This simple step can prove key to ensuring that the IRA is treated as an inherited IRA at all future times—once the non-spouse beneficiary accidentally makes a move that is not permitted with inherited IRAs, he or she will lose the benefit of the stretch tax deferral.

Conclusion

Post-SECURE Act, the rules governing distributions from inherited retirement accounts are more complex. All clients should seek competent advice about their specific situation before making any move toward taking money from the inherited account or executing a rollover transaction.