The SECURE Act, passed by Congress at the end of 2019, has a big impact on non-spouse IRA beneficiaries, especially those beneficiaries who would inherit large non-Roth IRAs.
One of the SECURE Act's most significant changes is the 10-year stretch limitation for most non-spouse beneficiaries. The rule does not apply to spousal beneficiaries or disabled beneficiaries.
Under the new regulations, beneficiaries of both traditional and Roth IRAs have 10 years to withdraw the funds. There is no required minimum distribution for traditional IRAs until the final year.
For the first nine years, the beneficiary can withdraw as much or as little as he or she wishes, but any funds remaining in the IRA must be withdrawn by the end of the 10th year, which can mean a big tax hit.
Beneficiaries of Roth IRAs may make tax-free withdrawals for any of the 10 years subsequent to becoming a beneficiary. However, they must also withdraw all the funds by the end of the 10th year to avoid any penalties.
In order to avoid a large income tax bill for the 10th year, the beneficiary of a traditional IRA should consider withdrawals in the first nine years. Even though any withdrawals from traditional IRAs will be taxable, waiting until year 10 can create a huge tax obligation and push the beneficiary into a higher marginal tax bracket.
Considering the change, IRA owners may want to take some action to minimize the income tax burden of non-spouse beneficiaries. Fortunately, owners can still name their spouse as a beneficiary. Spouses are not subject to the 10-year stretch rule.
Accordingly, one action the IRA owner can take is to leave a larger portion of the IRA to the spouse, who can convert the IRA to his or her name. Then, the spouse can name the same non-spouse beneficiaries of his or her IRA. This approach allows the withdrawal period to continue longer as the spouse does not have a 10-year stretch limitation. Of course, it depends on the surviving spouse not changing his or her mind about the plan.
Another option an owner of a traditional IRA could consider is to convert it to a Roth IRA. Often, the marginal tax bracket of an IRA owner is lower than that of his or her beneficiary at the point when the latter would be forced to make withdrawals. A traditional IRA owner may conduct the transfer over multiple years to avoid substantial income taxes in one year. The beneficiary of the Roth IRA would avoid income taxes after the account has been open for five years.
The IRA owner could consider buying life insurance, naming the non-spouse beneficiaries who are now named as beneficiaries of the IRA. The proceeds will be tax-free, there is no investment risk, and the payment is guaranteed. If other funds are not available, funds could be withdrawn from the IRA to pay the premiums.
Conduit trusts, which are designed to provide distributions to the beneficiary greater than the required RMD, no longer work. Because the only RMD will be at the end of 10 years, there would no longer be trust protection. Accordingly, if you have used a conduit trust, you should discuss other options with your attorney.
The bottom line is that limiting the stretch option has significant financial implications, and IRA owners and non-spouse beneficiaries should be considering other options.
Elliot Raphaelson welcomes your questions and comments at [email protected].