In January, the SECURE Act implemented changes to longstanding federal tax rules about the way that most Americans’ retirement accounts must be administered. There have been many headlines announcing the increased age for beginning required minimum distributions from individual retirement accounts (now 72, up from 70.5), but an equally important change that doesn’t fit neatly into a headline is that the rules for how an account balance is treated upon the death of the account owner have changed significantly, and those changes could impact many families.
As a baseline, it is important to remember a few key concepts about retirement accounts. First, individual retirement accounts have a “required beginning date,” which is the defined age of the account owner at which the owner must begin making annual withdrawals from the account. (This is now age 72 for most people who have not yet begun taking required withdrawals.) The annual withdrawals must be in an amount equal to at least the percentage of the account set by the IRS regulations, based on the age and life expectancy of the account owner. This annual amount is called the “required minimum distribution.”
Individual retirement accounts (IRAs) are often a significant portion of a retired person’s assets, and many people expect that their IRAs will be vehicles for transferring wealth to family and loved ones upon their deaths. When we contemplate estate planning, of course we are concerned with naming the correct intended beneficiaries and fiduciaries, but we do so with an eye toward tax planning as well. Planning to minimize the tax impact for inherited assets means that we are maximizing the wealth transferred to beneficiaries.
For most assets, the beneficiary is not burdened by significant income tax generated by the inherited assets because the assets receive a “stepped-up” basis to the date of death, meaning that for tax purposes, the asset’s tax basis is the asset value as of date of death, not the basis of the deceased. With traditional IRAs, however, there is no step-up in basis upon death; the basis is the same for the account owner and his or her beneficiary upon death. Because traditional retirement accounts are typically funded with pre-tax income, they are taxed when the funds are withdrawn (or “distributed” in retirement-speak). So, a beneficiary who inherits an individual retirement account also inherits the deceased person’s basis in that account and, therefore, the resulting taxable income as funds are distributed from the account.
As the adage goes, when you cannot avoid the tax, you should seek to defer it. Under the previous IRA tax code rules, we were able to defer the income tax associated with distributions from the account by stretching the distributions over as long a period as possible. This was accomplished by naming a younger person (i.e., someone with a longer life expectancy) to spread the required minimum payments out over the longest possible period of time.
Under the new rules, the ability to stretch the payment period has been limited, regardless of the age of the individual named as beneficiary. Now, when a deceased account owner names an individual as a beneficiary (called a “Designated Beneficiary” under the Code), the beneficiary must fully withdraw the account within 10 years after the owner’s death, unless the beneficiary falls into a class of “Eligible Designated Beneficiaries” described below. While the account must be fully distributed in that ten-year period, the distributions need not be taken annually or on an equal basis – if it’s preferred by the beneficiary (or advantageous to minimize income tax due), the entire account balance could be withdrawn in year 10 with no distributions in the first nine years. The “required minimum distribution” concept is no longer relevant to most individual beneficiaries of inherited IRAs.
The SECURE Act provisions create a special class of beneficiaries called “Eligible Designated Beneficiaries” who continue to have the ability to stretch payments over a period longer than ten years. The Eligible Designated Beneficiary class contains four groups: surviving spouses; minor children; disabled or chronically ill beneficiaries; and beneficiaries not more than 10 years younger than the account owner.
For the surviving spouse of the account owner, the rules as an “Eligible Designated Beneficiary” are largely the same as the rules that were in place before the January 2020 changes. A surviving spouse has the option of treating an IRA inherited from a spouse as his or her own IRA. Depending on how the surviving spouse elects to treat the inherited IRA, the distributions will still be spread over either the surviving spouse’s own life expectancy or the remaining actuarial life expectancy of the deceased spouse.
For minor children of the account owner who are named as beneficiaries, the rules give something of a tolling effect to the period of minority. While the child is a minor, the required minimum distributions will be based on the life expectancy of the child (and therefore will be very small), but when the child reaches the age of majority under his or her state’s law, then the account must be distributed within 10 years. There may be a deferral available beyond the legal age of majority if the child is enrolled in a “specified course of education” that meets the requirements under the Code. This deferral period goes to a maximum of age 26, which means the account would need to be fully distributed, at latest, by the time the beneficiary reaches age 36. It is important to note that a minor child is only an “Eligible Designated Beneficiary” if his or her parent is the deceased account owner; the child would not qualify as an “Eligible Designated Beneficiary” if the account owner were, for example, a grandparent.
For the “disabled or chronically ill” category of Eligible Designated Beneficiaries, the Code sets out specific requirements as to who qualifies as “disabled” and/or “chronically ill”. The determination of whether a beneficiary qualifies is made as of the date of death of the account owner, not at the time the beneficiary designation is made. The distribution period of the account for a qualified disabled or chronically ill beneficiary is based on the life expectancy of the beneficiary. (If the disability or chronic illness ceases during the lifetime of the beneficiary, the “eligible designated beneficiary” status will also terminate, and the ten-year distribution period will then apply.)
Finally, a beneficiary who is not more than ten years younger than the account owner is also an “Eligible Designated Beneficiary.” These beneficiaries are permitted to take distributions based on their own life expectancies.
One thing that remains unchanged under the revised law is that the shortest distribution period applies to accounts from which the owner has not begun taking distributions prior to death and no individual beneficiary is named. In this case, if the beneficiary is the estate of an account holder or another non-individual entity (for example, a non-qualifying trust), then the account must be fully distributed within five years of the account owner’s death.
There are still opportunities for tax planning and legacy preservation under the revised rules governing IRA distributions after the death of the account owner, though they may be more limited than in the past. Among others, strategies may include structuring an estate plan to name Eligible Designated Beneficiaries as IRA beneficiaries and directing other assets toward individuals who would not qualify as Eligible Designated Beneficiaries, or naming as beneficiary a certain type of charitable trust that allows for income to individual beneficiaries over a period of years, with the remaining account balance being paid to a qualified charity. The IRA owner’s individual circumstances, as well as those of his or her intended beneficiaries, will need to be considered to develop an appropriate plan.
If your estate planning currently includes the strategy of naming younger people as beneficiaries for the purpose of tax deferral, it would be wise to talk to your financial and legal advisors about whether this is still the best approach for your circumstances.