The SECURE Act as passed by the House of Representatives would replace the 5-year distribution rule for inherited IRAs with a 10-year rule. It would also eliminate “stretch IRAs.”
If passed by the Senate, the changes would kick in for plan participants or IRA owners who die after 2019. Limited exceptions would apply for narrow classes of beneficiaries and plans.
Required Minimum Distributions (RMDs) and the SECURE Act
The tax code heavily subsidizes retirement savings. Contributions to IRAs and retirement plan are not taxed until distributed after retirement. Meanwhile, investments grow tax free. This is a costly benefit for the U.S. Treasury, but Congress thinks it’s worth it so that retirees who need income have it.
The temptation for retirees is to draw on their IRAs as a last resort for the following reasons:
- distributions are fully taxable;
- investment income from distributed amounts is no longer tax sheltered; and
- accumulating assets in an IRA is a good way to pass on a lifetime of untaxed income to a beneficiary.
To counter this temptation, required minimum distributions (RMDs) are keyed to the retiree’s life expectancy. As a result, IRA and plan assets will likely be mostly distributed and mostly taxed to the retiree or retiree’s spouse if they live long enough.
RMD rules for the post-death period provide special rules to keep the tax benefits going for surviving spouses. The SECURE Act would not change that. However, current rules also allow properly set up inherited IRAs to drip out RMDs for the life expectancy of a nonspouse beneficiary. These are “stretch” IRAs, and the SECURE Act would mostly eliminate these.
Inherited IRA Distribution Options under RMD Rules
When an IRA-owner dies, the IRA passes as an “inherited IRA.” Beneficiaries can make withdrawals for themselves, but unless they are a spouse who is the sole beneficiary they cannot treat the IRA as their own.
A beneficiary of an inherited IRA can take a full distribution of the assets on the death of the owner. However, that could result in spike in income. That could result in a very large income tax bill as the beneficiary is pushed in a much higher bracket. Beneficiaries do have some options, however.
Taking distributions over a period of up to five years is an option that smooths out income and thereby helps avoid higher tax brackets. Under the 5-year rule, an IRA beneficiary must withdraw 100 percent of the IRA by December 31 of the year containing the fifth anniversary of the owner’s death. Note that a beneficiary does not need to spread distributions out evenly over five years. A beneficiary can simply wait until the fifth year.
Life Expectancy Rules
For those who do not currently need the extra income, the best strategy is to avoid distributions as long as possible by pegging the distribution period to someone’s life expectancy. Distributions must be taken annually under these rules.
Factors Determining the Distribution Period
The extent to which the distribution period of an inherited IRA can be stretched depends on whether:
- the beneficiary is a “designated beneficiary”;
- the beneficiary is the surviving spouse; and
- the IRA owner dies before the required beginning date (RBD) for RMDs.
Types of Beneficiaries
A beneficiary is the individual, group of individuals, or entity (e.g., estate) named as a beneficiary on an IRA account as of date of the owner’s death.
“Designated beneficiaries” are individual beneficiaries who have not cashed out or disclaimed their interest as of September 30 of the year after the owner’s death. It matters whether a beneficiary is a designated beneficiary for purposes of determining the distribution period of an inherited IRA.
To qualify as a designated beneficiary, the beneficiary must be an individual with a quantifiable life expectancy. The one exception is if a see-through trust is named as the beneficiary, in which case the trust beneficiaries are treated as designated beneficiaries for RMD rules. Because they are not individuals, estates, charities, LLCs, and trusts (unless they qualify as see-through trusts) cannot be designated beneficiaries.
Comment: The September 30th identification date gives time for beneficiaries to disclaim their interest in the IRA (beneficiaries generally have up to nine months after the date of death to disclaim). If a designated beneficiary dies before the September 30th date and has not disclaimed, the beneficiary continues to be treated as a designated beneficiary. Note that a beneficiary may take an RMD in the year of the owner’s death, and still be able to disclaim.
A designated beneficiary who is a surviving spouse and sole beneficiary can roll over the IRA into the spouse’s own IRA or “elect” to treat the inherited IRA as his or her own by failing to take RMDs. If the spouse wants to treat the IRA as an inherited IRA, the spouse gets more favorable treatment than nonspouse designated beneficiaries as discussed below.
Required Beginning Date (RBD) for RMDs
In addition to whether the beneficiary is a designated beneficiary, it matters whether the owner dies before the required beginning date (RBD) for RMDs.
The RBD for distributions from a traditional IRA is April 1 of the year following the year in which the individual attains age 70 ½. An individual attains age 70 ½ as of the date six calendar months after the 70th anniversary of the employee’s birth. Note that RBDs for employer plans can be later if an employee is still working for the employer.
Comment: The SECURE Act would push the RBD age 70 ½ requirement to age 72. The change is a recognition that people live longer. It is paid for by the change in stretch IRA rules.
Death Before RBD
Non-designated beneficiary. The five-year rule is used.
Nonspouse designated beneficiary. Unless the beneficiary elects to use the 5-year rule, RMDs must begin by December 31 of the year following the owner’s death. The distribution period is the beneficiary’s life expectancy at the beneficiary’s birthday in the year following the owner’s death. The period is reduced by one each succeeding year.
Spouse who is sole beneficiary. The spouse who rolls over uses his or her own age to determine RBD. A spouse who takes an inherited IRA must start by the later of the end of the calendar year following the year of death, or the calendar year the owner would have reached age 70½. The spouse’s life expectancy is recalculated every year.
Death on or After RBD
Non-designated beneficiaries. If death occurs on or after their RBD, distributions can be made based on the life expectancy of the deceased owner computed as of the year of his or her death. This is sometimes called the “ghost” life expectancy rule.
Designated beneficiaries. The distribution period is the longer of:
- the beneficiary’s life expectancy based on beneficiary’s age at the beneficiary’s birthday in the year after death the owner’s death, or
- the owner’s age at the owner’s birthday in the year of death.
This distribution is reduced by one each succeeding year. This rule is stingier than it is for owner’s who are still alive. They recalculate every year.
Surviving spouse sole designated beneficiary. Spouse’s follow the same rule, except if the distribution period is based on their age is it recalculated each year. The same holds true for a spouse who treats the IRA as the spouse’s own.
SECURE Act Changes for Nonspouse Designated Beneficiaries
All distributions must generally be completed within a 10-year period beginning in the year following the year the participant or IRA owner dies. Thus, the 10-year period replaces the 5-year default period. However, unlike prior law, the 10-year period would apply regardless of whether the plan participant or IRA owner dies before or after reaching the RBD. The change would apply to distributions to a non-spouse beneficiary from retirement plans and IRAs (including Roth IRAs) made after the death of the plan participant or IRA owner who dies after December 31, 2019.
Limited exceptions apply for:
- a newly created class of individuals called “eligible designated beneficiaries”;
- collectively bargained plans;
- certain governmental plans; and
- existing annuity contracts.
Newly Created Class of “Eligible Designated Beneficiaries”
The 10-year distribution limit would not apply to eligible designated beneficiaries. These include:
- a surviving spouse;
- a minor child;
- a disabled individual; and
- an individual who is not more than 10 years younger than the deceased participant or IRA owner.
The exception for a minor child would no longer apply once the child reaches the age of majority. Accordingly, the remainder of the distributions to that individual must be completed within 10 years after that date.
Disabled individual for these purpose include those who are unable to engage in any substantial gainful activity due to a medically determinable physical or mental impairment. It would also include the chronically ill individuals whose period of inability to perform at least two activities of daily living, such as bathing, dressing, or toileting, has been certified as indefinite and is expected to be lengthy.
The determination as to the existence of an eligible designated beneficiary will be made as of the death of the plan participant or IRA owner.
For most inherited IRA beneficiaries, the 10-year rule will provide far more flexibility for timing distributions than the existing 5-year rule.
For estate plan planners, the near elimination of stretch IRAs will require review of current strategies.
By James Solheim, J.D.