The Setting Every Community Up for Retirement Enhancement (SECURE) Act was passed in December 2019, and its “sequel,” the SECURE Act 2.0 was passed a few years later in December 2022. While the list of changes from these two pieces of legislation could warrant a short novel, let’s take some time to dissect a related issue I have been helping next-generation clients with.
In IRAs and pre-tax retirement accounts, workers save their dollars on a pre- or post-tax (Roth) basis with the intention of accumulating dollars for retirement. For our purposes, I am going to focus more on the traditional (pre-tax) side of things, because these are the account balances that tend to cause the most grief for future beneficiaries.
Pre-SECURE Act Beneficiary Options
Required minimum distributions are required withdrawals from pre-tax retirement accounts that the IRS forces you to take once you reach a certain age (as of the passing of the SECURE Act 2.0, this age is 73, but it’s set to increase to 75 in the future). Pre-SECURE Act, if the owner of an IRA or employer-sponsored retirement plan died and named a non-spouse individual as beneficiary, the new beneficiary was eligible for a lifetime “stretch” RMD.
For example, Jack names his granddaughter Jill (age 3) as a 100% beneficiary of his Traditional IRA. He is a widower, and his son John (Jill’s dad) is a successful entrepreneur with more than enough assets in his own name.
By naming Jill as beneficiary of his IRA, Jack is not only guaranteeing that money passes to his granddaughter directly, but he also knows that the potential accumulation of the IRA over a period that could last many decades will be a powerful asset for his granddaughter to own.
Pre-SECURE Act, the RMD taken from Jill’s inherited IRA would be insignificant thanks to the payments being based on her life expectancy.
With very little being forced out over the beginning of her lifetime, a large enough balance with proper investment management could last long enough to contribute to her college expenses, first house, and maybe even her own retirement. Also, Jill’s parents wouldn’t be burdened with much of a tax liability in comparison to the account balance their daughter inherited.
Post-SECURE Act Beneficiary Designations
In the post-SECURE Act world, this is no longer the case. There are now Eligible and Non-Eligible Designated Beneficiaries. To understand the difference, it is easiest to identify the Eligible Designated Beneficiary (EDB). To be considered an EDB, one must meet at least one of the following criteria:
- A surviving spouse
- Minor child beneficiary (of the original account owner) under 18
- A disabled individual
- A chronically ill individual
- Any other individual who is not more than 10 years younger than the deceased account owner
Everyone else, including adult children and grandchildren of any age, are not considered an EDB. If Jill inherits a Traditional IRA from her grandfather at age 3, it is no longer a small inconvenience to have to satisfy the “stretch” RMD.
Instead, she has 10 years from the year following Jack’s death to fully deplete (pay the tax) on the inherited IRA. In addition, if Jack was of RMD age himself, Jill now has an annual RMD during the first 9 years of the 10-year period, with the remainder to be distributed in the final year.
I focus on Traditional IRAs in my hypothetical because had Jack paid his tax in advance by contributing to a Roth IRA or performing Roth conversions, Jill would still have a 10-year window to deplete the account, but there would be no tax due on the distributions, and there would be no annual RMD, regardless of Jack’s age at death. And in this situation, it’s generally advisable that you let the account grow as long as possible before taking distributions to take advantage of fully compounded, tax-free growth.
Should the complexity of the SECURE Act change the way investors designate their IRA beneficiaries? It depends. If the IRA owners have a spouse they can leave it to, it is advisable to do so.
It is not uncommon for clients to cut in their children or grandchildren for some percentage of their Traditional IRA, especially if they have sufficient assets to be able to part ways with some of them at the death of the first spouse. Now, the complexities may be best left for the second of the two spouses to die.
Tax Implications in the Post-SECURE Act
I have the benefit of working with clients across a few generations, which means that I have helped clients with beneficiary plans, as well as helping the children and grandchildren who have recently inherited assets. Usually, there ends up being a child or grandchild who has become burdened with a fully taxable, post-SECURE Act IRA inheritance with a 10-year ticking clock in the background. I understand their concern or frustration with the complexity of the rules and not knowing the best way to handle distributions.
Besides the 10-year rule and annual RMDs for some beneficiaries, the rest of the equation is very flexible. That is why I recommend that the receipt of an inherited IRA be accompanied by a tax analysis and projection.
In many ways, my recommendations around paying the tax on an inherited IRA are similar to my work with clients considering Roth conversions. It is a conversation about current-year and future-year income, current and future tax brackets, and income consequences.
Below are some opportunities related to tax planning around the inheritance of a post-SECURE Act IRA, whether you are doing the planning for yourself, your minor child, or both:
Take Advantage of Low-Income Tax Years
In retirement planning, there is usually a handful of golden years right after you retire but before you receive Social Security where your income on paper is very low. This is an opportunity to fill up lower tax brackets with Roth IRA conversions.
As mentioned before, the process of accelerating or delaying distributions from an inherited IRA works much the same.
Loss of a job, transition to self-employment, transition to a variable pay position, or one parent transitioning to caregiver are all examples where a person’s taxable income may be lower than usual. Use those years as an opportunity to distribute more of the inherited IRA and get ahead of the game.
Work with an advisor or Certified Public Accountant (CPA) to target an amount of taxable income you believe is acceptable (likely targeting a certain tax bracket).
Fund Your Own Retirement Accounts
Inherited IRAs must be maintained as entirely distinct from your other retirement assets. Inherited Roth IRAs would be in a separate account from Inherited Traditional IRAs, as well. In addition, you are not allowed to convert an inherited IRA balance to a Roth IRA in your own name.
However, you can use the money distributed from an inherited IRA to contribute to your own retirement account, assuming you already qualify.
For instance, consider the case of John, who inherits a large IRA from his father, Jack. John and his wife, Judy, typically contribute 6% of their income to their pre-tax 401(k) at their jobs. For both, this is enough to receive the full employer-sponsored match, however, due to daycare expenses for their daughter, Jill, they cannot afford to save more.
Here's where the inherited IRA comes into the picture. Distributions from the inherited IRA will go onto their tax return via a 1099-R. Once they have the money in their bank account, they can live off the proceeds in lieu of their W-2 income from work.
Why? Because now they can both defer more of their pay into their own 401(k)s. Thanks to the large inheritance, they are able to take out enough from the IRA for both of them to max fund their retirement accounts, and the tax due on the distributions is fully offset by the contributions to the 401(k).
Consider Time-Weighted Distributions
Time weighing your distributions is a good strategy to address the inherited IRA distributions if you do not anticipate a substantial drop or increase in income over the coming years. If you are already maxing out your pre-tax retirement plans, it might make sense to smooth out the distributions over the course of the 10-year period.
The table below shows a hypothetical time-weighted distribution schedule, assuming that the account is also earning 5% a year.
The ending account value in each year is growing at a constant rate while being divided by one less year every year. You can see that the distribution in the final year is nearly triple that of the initial year, but with inflation’s impact on tax brackets over time, the amount of income tax realized should be similar.
This can also be customized to your situation with the help of a tax professional. Also, your distributions can be adjusted for market outperformance or underperformance from your initial assumed rate.
Time a Minor Child’s Inheritance
The few strategies/opportunities highlighted above are primarily for working adult beneficiaries, but there is a slight overlap for their children who may be the recipients of an inherited IRA. Because grandchildren are not considered EDB under the SECURE Act 2.0, some will be subject to a 10-year clock and potentially forced to take annual RMDs while still under 18.
If a child is 15 or younger by the 10th year of the inherited IRA, the tax considerations are primarily based on the parents’ tax situation. Using low-income-year and time-weighted distribution strategies should make sure that a large lump sum in year 10 doesn’t come with adverse tax impacts for the future owner of the account.
As distributions exit the inherited IRA, they should enter a Uniform Transfers to Minors Act (UTMA) account in the child’s name, not an account in the name of the parent. The UTMA account can continue to be invested, but keep in mind that the earnings in a UTMA are not tax-deferred like in an IRA.
How Inherited IRAs May Affect Student Loans
Children who are at least 16 years old by the end of the 10-year period may have more complexities to consider, depending on when/whether they are applying for college.
If a child inherits an IRA in 2022, the final year for distributions would be 2032. Because of the Free Application for Federal Student Aid (FAFSA) and a two-year lookback, the distributions in 2032 can be included in the child’s income all the way to the year 2034.
This would be a good time to quickly note the differences in FAFSA treatment for accounts and distributions. An inherited IRA balance itself is not reportable on the FAFSA. Distributions from an inherited IRA within two years of the application would be countable as student income, which is most highly weighted against them on a FAFSA application.
UTMA accounts are considered a student asset, which is not as bad as student income, but isn’t as favorable as a parent’s asset.
Depending on the child’s age at inheritance, you might either accelerate distributions to empty the inherited IRA before the years that would show up on FAFSA. Or, if the child was in their teens at inheritance, consider delaying distributions apart from the annual RMDs, if applicable.
Where to Go from Here
The above only gets more complex in situations where multiple members of the same household inherit portions of the same IRA from a grandparent. You may need to balance the taxable income of you and your spouse with your own inherited IRA distributions, plus that of your children, all of whom will be different ages and with different circumstances over the next 10 years!
If your head is spinning from all of this, don’t worry. Thanks to the complexity of the SECURE Act, RMDs have been waived every year since its passage, including in 2023. This means if you haven’t gotten around to the type of planning featured above, there’s still time to seek guidance from an advisor to put together an income projection and distribution schedule.
