One of the most significant assets many individuals leave behind for their loved ones may be the balance in their IRA, or Individual Retirement Account. Before the Secure Act’s passage on January 1 of this year, legislation allowed for beneficiaries of IRA accounts to stretch out the required minimum distributions over their lifetime. This strategy minimized the tax burden on the withdrawals, and the resulting tax deferral could span decades.
What Does the SECURE Act Change?
The previous rules allowed a non-spousal beneficiary an option that would let them take minimum distributions over their life expectancy. Their life expectancy would be calculated by factors such as the beneficiary’s age, account balance, and anticipated life expectancy. The SECURE Act eliminated this option and now mandates that the account must be emptied and closed within ten years, regardless of the resulting tax implications.
The prior laws allowed what was commonly referred to as a stretch IRA, which meant that a younger beneficiary, such as someone in their twenties or thirties, could elect to stretch the distributions for 50-60+ years (depending upon the IRS life expectancy tables that govern this strategy). In this scenario, an individual would frequently be drawing an annual amount that is far lower than the investment gains that are still made by the remaining balance, which would allow the account to continue to grow.
The SECURE Act no longer permits this, and no matter what the tax ramifications are for the non-spousal beneficiary. However, there are Eligible Designated Beneficiaries, who may still be exempted from the provisions in the SECURE Act.
What Do the Changes Mean for Beneficiaries?
If a beneficiary inherits an IRA with a relatively small balance, the potential tax benefits of a stretch IRA likely won’t be reaped, and the passage of the SECURE Act will have a minimal impact on them.
For non-spouse beneficiaries who inherit a substantial IRA, the tax burden will likely be much larger than it would be prior to the SECURE Act. But there is one bright spot in the changes. They are no longer required to take a minimum distribution each year but must simply withdraw the funds at some point in time within the ten-year window. With some planning, the tax burden can be minimized. For instance, the beneficiary could elect to withdraw less in high-income years and withdraw more during low-income years, which can mitigate some of the tax impacts.
What Are Eligible Designated Beneficiaries?
The SECURE Act did away with the stretch IRA but did create an exempted class of designated beneficiaries who do not have to adhere to the 10-year payout provision strictly. In addition to those who inherited prior to 2020, the following individuals enjoy greater flexibility and freedom to extend their distributions on an inherited IRA.
- Surviving spouses: Are exempt from the SECURE Act and may still stretch their minimum distributions or retitle the IRA into their own name.
- Minor children of the account holder: The ten-year rule goes into effect only when the child reaches the age of majority, or the age of 26 if still in school. Grandchildren are ineligible for this benefit.
- Chronically ill/disabled beneficiaries: Similar to spouses, these beneficiaries are exempt from the changes of the SECURE Act.
- Individuals who are not more than ten years younger than the IRA owner: These individuals may be a friend, sibling, or unmarried partner.
Is There Anything I Can Do to Minimize the Tax Impact for Other Beneficiaries?
While the SECURE Act represents major changes – and a tremendous difference in the tax burden – for many beneficiaries of IRAs, there are some ways to minimize the tax impact of these changes. For starters, you can convert a part of, or all of, your IRA into a Roth IRA. This strategy can be carried out over several years to ensure your income doesn’t push you into a higher bracket. While beneficiaries will still be subject to the ten-year rule, the portion in the Roth IRA will be tax-free.
Making qualified charitable distributions can also soften the tax impact for you and your beneficiaries, as these distributions are not included in income. Certain types of trusts, such as those that give the trustee discretion on whether to pay out or retain required minimum distributions, can be employed to also avoid the scenario of having a large distribution (and hefty tax burden). If you are unsure whether the SECURE Act will impact your IRA beneficiaries or you would like to learn more about how to minimize impacted IRAs, it is worth exploring your options with an experienced estate planner - this is the best way to ensure that your hard-earned assets can benefit your loved ones.