The SECURE Act as passed at the end of 2019 pushes back the beginning date for required minimum distributions (RMDs). It also replaces the life-expectancy distribution period for non-spouse designated beneficiaries with a 10-year distribution period.
The first change makes it easier for retirees to keep their retirement assets undistributed and untaxed for a bit longer into retirement. The second change poses a tax challenge for the children of the wealthy and will likely cause estate planners to rethink existing choices and plans.
Required Beginning Date (RBD) for RMDs Pushed Back to Age 72
The SECURE Act changes the required beginning date for taking RMDs. Under the old rule, the first year for which an account holder had to take an RMD was the year the account holder turned age 70 ½. The required beginning date would be April 1 of the calendar year following that year.
Example. Doris was born June 30, 1949. She turns age 70 ½ on December 31, 2019. She has to take an RMD for 2019. She can put that distribution off until April 1 of 2020, which is considered her “required beginning date.” After that, she has to take her RMD by December 31 of the RMD year. For her 2020 RMD, that would be December 31, 2020.
The SECURE Act does not change this treatment for people like Doris who turned age 70 ½ in 2019. But it does change the rule for people turning age 70 ½ after 2019.
Example. Harold was born July 1, 1949. He turns age 70 ½ on January 1, 2020. Harold’s first RMD year is the year he reaches age 72, which is 2021. His required beginning date is April 1, 2022. After that, he has to take his RMD by December 31 of the RMD year. For his 2022 RMD, that would be December 31, 2022.
Comment: This change means that retirees who can afford to delay taking distributions from their IRA or employer plan can to some extent postpone depleting their balance and paying big tax bills.
Comment: Note that the IRS is revising its distribution tables to reflect changes in longevity. This means RMDs will be somewhat smaller than they otherwise would be.
Stretch IRAs for Nonspouse Designated Beneficiaries Eliminated
The SECURE Act changes the rules for determining the distribution period for inherited IRAs for designated beneficiaries who are not a surviving spouse. The changes take place with respect to employees and IRA owners who die after December 31, 2019.
Designated beneficiaries only include natural persons (i.e., humans with a life expectancy). Nondesignated beneficiaries include institutions and legal entities, including estates, charities, and trusts that do not qualify as “see-through” for these purposes. They can also include any human who for whatever reason fails to qualify as a designated beneficiary.
The SECURE Act changes the distribution rules for those designated beneficiaries who may be children, domestic partners, siblings, or other relatives or friends. These types of designated beneficiaries used to be able to use their own life expectancy as determined in the year of the account owner’s death. For designated beneficiaries taking with respect to an owner or employee who dies after December 31, 2019, the distribution period is a maximum of 10 years.
Non-designated beneficiaries have up until five years to distribute the entire account balance of an inherited IRA. Although the five -year rule is designed to allow beneficiaries to spread out taxable distributions to smooth out increased tax liability, beneficiaries may wait until the end of the period to take the entire distribution.
If required minimum distributions have begun, a non-designated beneficiary can still use the deceased owner’s life expectancy as the distribution period if that period is longer. This is sometimes called the owner’s “ghost life expectancy.” The SECURE Act does not change the rules for nondesignated beneficiaries.
Life Expectancy Rule
A surviving spouse who is the sole beneficiary can treat an inherited IRA as the spouse’s own IRA. Or they can treat it as an inherited IRA, using their own life expectancy as recalculated each subsequent RMD year to determine the distribution period. The SECURE Act does not change these rules.
Exceptions to the 10-year rule. Note that some designated beneficiaries will continue to operate under the old rules using the beneficiary’s life expectancy. Limited exceptions to the 10-year rule apply for: a newly created class of individuals called “eligible designated beneficiaries” collectively bargained plans; certain governmental plans; and existing annuity contracts.
Eligible designated beneficiaries who are excepted from the 10-year distribution limit would include:
- surviving spouses;
- minor children;
- disabled or chronically ill individual; and
- individuals not more than 10 years younger than the deceased participant or IRA owner.
The exception for a minor child no longer applies once the child reaches the age of majority (18 in most states). Accordingly, the remainder of the distributions to that individual must be completed within 10 years after that date. The Act itself does not specify how to identify a minor.
Transition. If an IRA owner or employee dies before December 31, 2019, and a designated beneficiary dies after that date, the designated beneficiary will be treated as an eligible beneficiary. However, the beneficiary of the designated beneficiary has to actually qualify as an eligible designated beneficiary to be treated as such. Otherwise, that individual will be subject to the 10-year rule.
What Can be Done?
A problem created by the 10-year rule is that children who are designated beneficiaries to their parents’ IRAs are likely to be in their peak earning years. That means their income will be bunched, and they will be pushed into higher tax brackets. Beyond targeting IRA distributions towards eligible designated beneficiaries, here are some possible ways to handle this:
- target IRA assets towards younger or more lightly taxed designated beneficiaries;
- spread out IRA assets among a broader range of designated beneficiaries so that bunching is less of a problem;
- target IRAs for charitable giving;
- take extra taxable distributions to make gifts;
- use extra taxable distributions to buy life insurance or annuities for the benefit of nonspouse family or friends; and
- use extra taxable distributions to pay tax on Roth IRA conversions which though subject to the 10-year rule are not taxed when distributed.
On balance, the changes help middle income retirees by giving them more room to keep their retirement powder dry. The elimination of stretch IRAs for nonspouse designated beneficiaries, however, makes it harder for wealthier families to pass on wealth to children who are their peak earning years. Estate and financial planners who have been able to take for granted that an inherited IRA would smoothly spread out taxable income for a young beneficiary’s life time will need to review their approach.
By James Solheim, J.D.