Trust Perspectives: Non-Spouse Inherited IRA Rule Change

The SECURE Act, passed in December, 2019, contained an important provision which changed the rules for distributing assets from an inherited IRA upon the death of the owner.

Prior to this change, many non-spousal inheritors of IRAs opted to take distributions over their life expectancy, in accordance with the appropriate IRS single life expectancy table. This “Stretch IRA” provision allowed the beneficiary to spread the distributions over an extended period of time thereby mitigating the tax implications of larger distributions.

Now, for IRAs inherited from original non-spouse owners who passed away on or after January 1, 2020, the new law requires many beneficiaries to withdraw all of the assets from an IRA or 401(k)/403(b) plan within 10 years following the death of the IRA owner. The result, for many inheritors who are still working, is added taxable income and for those already retired, an added consideration when planning around income levels that affect taxation of Social Security benefits and Medicare premium levels. In either case, this added income requires appropriate consideration of one’s individual circumstances. What may be an appropriate withdrawal strategy for one person may not be appropriate for someone else.

Here are some other considerations concerning the impact of the SECURE Act on inherited IRAs:

• While there is no annual RMD, you must distribute the assets from a non-spouse inherited IRA within 10 years. For example, you can take some assets out each year or just leave all assets in the account until the last day of the 10-year timeframe. The tax ramifications of waiting until the 10th year to withdraw substantial funds from the IRA may be severe as all distributions from a traditional IRA, unlike a Roth IRA, are taxed as ordinary income. Therefore, beneficiaries should be encouraged to make withdrawals of some amount every year, although they may benefit from measuring those annual withdrawals against their other income to better manage the tax liability.
• Those who saved a lot of money in their 401(k)/403(b) or IRA, and hope to leave that money to a non-spouse beneficiary, might want to rethink their strategy on who they choose as a beneficiary, recognizing this new, shorter timeframe. Or, consider more strategic withdrawals during their lifetime in order to “manage-out” the assets and tax rates.
• Other than the surviving spouse, you cannot roll the assets into your own IRA nor can you comingle them with any other inherited IRA assets you may have.
• There are some exceptions to the 10-year rule; a surviving spouse beneficiary can transfer the entire sum, tax free to an IRA of their own and address distributions as an original IRA owner. A minor child beneficiary, a disabled or chronically ill beneficiary or a beneficiary who is not more than 10 years younger than the original owner can “stretch” the payments over their life expectancy.
• After the SECURE Act, any trust named as beneficiary of an IRA should be reviewed. If the trust beneficiary has special needs this is especially important. For those special needs beneficiaries who are chronically ill or disabled, the SECURE Act does provide some guidance for a way forward that would still allow payments to a trust over the beneficiary’s life expectancy.
• Multiple listed beneficiaries of a non-spouse IRA will want to separate their portions of the decedent’s IRA to allow flexibility in withdrawal strategies suited best to the individual’s circumstances.
• Non-spouse beneficiaries do not have bankruptcy protection with inherited IRAs. In 2005, the US Supreme Court ruled that an inherited IRA held by a non-spouse beneficiary is not exempt from attachment by creditors. Some states may have laws that still protect inherited IRAs so be sure to get legal advice in this situation.
• Inherited Roth IRAs require similar distribution requirements. If you inherit a Roth IRA that was funded for 5 years or more prior to death of the owner, distributions can be taken tax-free. Check with a tax advisor if the Roth IRA wasn’t funded for 5 years before death of the original owner.
• The SECURE Act does not affect existing inherited accounts if the original owner died before December 31, 2019, thus allowing the stretch provision to be maintained.

Given the complexity of the new rules, it’s good to consult with knowledgeable financial planners, attorneys and tax professionals.