Although the new federal law called the Secure Act provides many advantages for people with retirement accounts, there also is a provision that can hurt beneficiaries who inherit those accounts. Good news: There are several possible strategies to reduce the financial harm.
How the new provision works: It requires that most beneficiaries of accounts such as IRAs and 401(k)s, other than a spouse, withdraw all the money within 10 years after the original account owner’s death—in contrast to the previous rules that allowed recipients to stretch out annual required minimum distributions (RMDs) based on each beneficiary’s lifetime expectancy. Under the new rules, any money left in accounts past 10 years is subject to a 50% IRS penalty. Exception: The so-called “Stretch IRA” option is still available for IRA and 401(k) accounts whose owners died before January 1, 2020, when the new law took effect.* (For more on the new law’s effects, go to “New Rules for Retirement and Education Savings Plans.”)
Why the new rules can be harmful: Withdrawing a large amount of money in an accelerated period could mean a much bigger tax bite than stretching out annual withdrawals over a longer period. Also, the old rules allowed inherited assets to grow tax-deferred in a retirement account (or tax-free for Roth accounts) much longer. Overall, the change could cost beneficiaries an estimated $15.7 billion in additional taxes over the next decade, according to the Congressional Research Service. Best strategies to reduce the harm…
For Account Holders
You can take various steps now to protect your beneficiaries later…
Bequeath more of your children’s inheritance to your spouse. Resist the common urge to leave a great deal of assets to your children. Reason: Without the advantage of the Stretch IRA, your children have fewer options to maximize the value of an inherited retirement account than your spouse does.
Example: Say you plan to leave a $1 million IRA to your 40-year-old son. But with just 10 years to empty the account, there’s little he could do to reduce a big overall tax bite even if he withdraws just $100,000 each year, which could push him into a high tax bracket.
Alternative: Leaving just half of that account to your son and the other half to your wife creates a more favorable tax outcome for your family.** Your wife gets to treat the inherited account as her own, which means she avoids RMDs altogether until age 72 (the new age at which RMDs must start under the Secure Act). At that point, she can start stretching distributions over her lifetime expectancy. That means her first-year RMD would be about $19,000, which would be less likely to push her into a high tax bracket. When your wife eventually dies, she can leave all or part of her account to the son, who then has another 10 years to withdraw all the money from the newly inherited account.
Don’t let trusts that you have set up with retirement accounts wreak havoc on your estate plan. Many people often designate a “conduit,” or “pass-through,” trust as the beneficiary of a retirement account. That gives them some control over how and when assets in the account will be distributed to their children after their death. But the new law complicates that strategy.
Example: A grandparent leaves a $2 million IRA in a conduit trust for his 21-year-old granddaughter with the stipulation that the girl will not receive the bulk of the money until ages 35 through 45, when she is presumably responsible enough to handle such a windfall. Under the old law, the trustee could spread RMDs over many years and delay any big distributions. Unfortunately, the new law undermines the grandparent’s wishes because under the new rules, the money must be completely dispersed from the IRA within 10 years, at which point the granddaughter is just 31.
Alternative: An “accumulation” trust. It works similarly to a conduit trust, and the IRA assets in the trust still must be withdrawn from the IRA within 10 years, but at the end of the 10 years, the trustee has the discretion to retain the funds in the trust and follow the distribution schedule you previously stipulated.
Use life insurance to reduce the tax burden on your beneficiaries. This is best for retirement account holders who don’t need to use any portion of their RMDs while they’re alive to pay their expenses. How it works: Use RMDs from your retirement accounts while you’re alive to pay premiums on a life insurance policy, whose eventual payout will be tax-free to the beneficiaries, unlike distributions from a taxable inherited retirement account. Even better, designate a trust as the beneficiary of life insurance proceeds to achieve similar results as in the section about trusts earlier.
Even if the original account holder does nothing to shelter beneficiaries from potential taxes, there still are a few steps nonspousal beneficiaries can take…
Beneficiaries should check whether they qualify for an exemption from the new law. Congress has classified certain individuals as “eligible designated beneficiaries” (EDBs). They follow pre-2020 IRS rules, which allows them to use the Stretch IRA strategy. EDBs include…
Any individual who is no more than 10 years younger than the deceased account owner. Example: Say you are part of an unmarried couple. Your partner dies at 80. You qualify if you are 70 or older.
A minor child of the deceased account owner. The child must take annual RMDs until he/she reaches the age of majority (18, 19 or 21 depending on his/her state of residence). From that date, the child no longer has to take annual distributions but must fully deplete the account within 10 years.
A disabled or chronically ill individual. The IRS has very strict definitions of these conditions, and they require a physician’s evaluation and recommendation.
If you inherit a non-Roth IRA, schedule your distributions strategically over 10 years. This can work better than waiting until the final year or taking so much in any year that it will push you into an unnecessarily high tax bracket. Example: If you’re nearing your own retirement, consider delaying withdrawals until the tax year after you stop working so that any distributions won’t be added to your wage income and possibly push you into a higher tax bracket.
If you inherit a Roth IRA or Roth 401(k), delay withdrawals until the 10th year unless you need the money sooner for expenses. Reason: Unlike with non-Roth retirement accounts, the distributions are not taxable, so postponing payouts until the end of the 10-year period maximizes the tax-free growth of investments in the account.
Roth vs. Non-Roth 401(k) vs. IRA
Although the Secure Act treats different types of retirement accounts similarly, there are significant distinctions…
Non-Roth 401(k): You can contribute up to $19,500 in pretax dollars from your paychecks for 2020 or up to $26,000 if you’re 50 or older. In addition, your employer may “match” a portion of your contributions, typically equal to a certain percentage, such as 50%, and up to a certain percentage of your salary, such as 6%. Withdrawals of contributions and investment earnings are taxed at your ordinary income tax rate at the time of withdrawal.
Roth 401(k): Contribution limits for 2020 are the same as for non-Roth 401(k)s, but contributions are made with after-tax dollars. And no employer matching can be added to the Roth 401(k). Withdrawals of contributions and earnings typically are not taxed.
Non-Roth IRA: You set up these accounts at investment firms rather than through your employer. You can contribute up to $6,000 for 2020…or up to $7,000 if you are 50 or older. You can take a state and federal tax deduction for your contributions, but the deductible amount may be limited based on your income level. The investment grows tax-deferred, and withdrawals are taxed at your ordinary income tax rate.
Roth IRA: Contribution limits are the same as for non-Roth IRAs. You don’t get a tax break when you make contributions, but withdrawals of contributions and earnings typically are not taxed.
Penalties: For non-Roth accounts—whether 401(k)s or IRAs—there typically is a 10% penalty on all withdrawals made before age 59½. For Roth accounts, there typically is a 10% penalty on early withdrawals of investment earnings but not on early withdrawals of contributions.
*The new rules do not apply to 403(b), 457 and Thrift Savings plans until January 1, 2022.
**Spouses are allowed to retitle the inherited account in their own name or transfer the assets into their existing IRA. There the money can grow tax-deferred or tax-free.