Part One: The New Landscape
At the beginning of 2020, the SECURE Act (Setting Every Community Up for Retirement Enhancement) went into effect. The SECURE Act substantially changed how inherited retirement accounts are taxed. The purpose of those provisions of the Act was to increase revenue for the federal government.
If tax-deferred retirement accounts (like 401(k)s and IRAs) are a significant part of your assets that you want to pass on after your death, consider changing your estate plan to accommodate the new and very different rules under the SECURE Act.* This article uses “IRA” to refer to any type of tax-deferred account.
The Stretch Inherited IRA is (Mostly) Dead
Prior to the SECURE Act, the beneficiary of your IRA could (a) take all the money, or other assets, out of the IRA right away and pay taxes on it; (b) take only their required minimum distributions (RMD) over their lifetime, pay taxes on those distributions, and leave the rest to grow tax-free; or (c) take more than the RMD, pay taxes on those distributions, and leave the rest to grow tax-free. The tax-free growth that was possible under options (b) and (c) is commonly referred to as the “stretch” because those options stretched the usefulness of the IRA — giving tax-deferred growth to the beneficiary over their lifetime rather than ending it at the death of the person who had contributed the money to the IRA (the “original owner”).**
Under the SECURE Act, options (b) and (c) above are no longer available for most beneficiaries. That is why the stretch inherited IRA is mostly dead.
Who Can Still Get the Stretch?
Two categories of beneficiaries can still get the stretch: Spouses of the original owner and “Eligible Designated Beneficiaries,” which means (a) individuals younger than the original owner by less than ten years or (b) certain disabled or chronically ill individuals as defined by the SECURE Act. Spouses of the original owner have other options as well, which the SECURE Act did not change.
The original owner’s minor children can also get a “mini-stretch” until they turn 18 and trigger the rules that apply to most other beneficiaries.
The Ten-Year Rule
Under the SECURE Act, individual beneficiaries who are not entitled to a stretch of the IRA must take everything out of the IRA within ten years of the original owner’s death. There are no RMDs during that period, but the entire IRA must be completely distributed by the end of the tenth year. Income taxes will be due, of course, on all distributions from a traditional IRA. The ten-year rule can also apply to trusts whose beneficiaries are all individuals.
The Five-Year Rule
Beneficiaries of an IRA which are not individuals – such as an estate and certain unqualified trusts – must take everything out of the IRA within five years of the original owner’s death. Like the ten-year rule, there are no RMDs during the five-year period, but the entire IRA must be completely distributed by the end of the fifth year, and income taxes will be due on all distributions from a traditional IRA.
Should You Update Your Estate Plan?
Updating your will, trust, and beneficiary designations on your retirement accounts in light of the SECURE Act will not affect the accounts or the money available to you during your retirement, but an estate plan that takes the SECURE Act into consideration could significantly increase the net amount your children or other non-spouse beneficiaries actually inherit from you.
*Note that not all 401(k)s will retain their tax-deferred qualities when inherited. If they will, they are generally converted to IRAs
**Although no taxes will be due on distributions from an inherited Roth IRA, taking all the money out of a Roth IRA still ends the tax-free growth the beneficiary could have enjoyed. Outside of the IRA, all growth will be taxable.
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