Inherited IRAs: How Advisors Can Help Clients Navigate New Rules

The SECURE Act, which became effective at the beginning of 2020, eliminated the “stretch IRA,” with the exception of some beneficiaries. However, the IRS is mulling over key provisions particular to distributions that advisors should keep an eye on.

The new 10-year rule will require earlier withdrawals, and key details, including a mandatory distribution for some beneficiaries in years one through nine, are still being hammered out in IRS regulations.

Financial advisors can help their clients navigate their inherited individual retirement accounts, or IRAs, post-SECURE Act, in order to help them minimize taxes and plan ahead.

Before the SECURE Act, those who inherited an IRA had an option to stretch out their payouts using their own life expectancy, which provided the opportunity for inheritors to delay and minimize withdrawals from their inherited IRAs, and therefore minimize taxes while keeping the funds invested for a longer period of time. This was particularly beneficial for younger inheritors, like a grandchild.

Although the stretch IRA option is gone for some, advisors can provide great value to their clients by helping them understand the complex new rules and implement strategies that may provide better planning opportunities.

In order to help clients in the best possible manner, here are some things that advisors should be aware of:

— When did the decedent die?

— What type of beneficiary is the client?

— The 10-year rule.

— The 5-year rule.

— Roth IRAs.

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When Did the Decedent Die?

Did the decedent die before or after the required beginning date, or RBD, for required minimum distributions, commonly known as RMDs? Prior to the SECURE Act, the RBD was generally by April 1 of the year after the IRA owner turned 70. Beginning in 2020, the age requirement was raised to age 72, providing IRA owners an additional two years to begin their required minimum distributions. When the original IRA owner dies, different rules will apply to the inherited IRA based on whether the decedent died before or after their required beginning date. This is extremely important, and it should be the first thing that advisors should determine.

What Type of Beneficiary Is the Client?

Not all beneficiaries are created equal. The SECURE Act provides special treatment to a separate class of beneficiaries, called eligible designated beneficiaries, or EDBs. EDBs can still stretch their IRAs until they die or are no longer qualified as an EDB. These beneficiaries must be named beneficiaries of the IRA, which is why it’s so important for advisors to help clients review their beneficiary forms and ensure that their desired beneficiaries are actually listed as such on the IRA beneficiary form. Eligible designated beneficiaries are any of the following:

— A surviving spouse.

— Minor children of the account owner, until age of majority (21).

— Disabled individuals that meet the IRS definition of disabled.

— Chronically ill individuals.

— Individuals who are not more than 10 years younger or older than the deceased account owner.

In addition to EDBs, conduit trusts that qualify as “see-through” — which looks to the beneficiary’s life expectancy — under IRS regulations can also use the stretch option, provided that the trust immediately pays the required minimum distribution to the beneficiary. This is a great planning opportunity for clients who want to leave money to a minor but don’t want to give them full access to the funds in the IRA immediately upon death of the account owner. However, once the child turns 21, they are no longer considered an eligible designated beneficiary, and the 10-year rule applies.

Surviving spouses typically have more options than non-spouse beneficiaries. One thing to keep in mind for spouse beneficiaries is if they are under the age of 59.5 when they inherit the IRA. Upon inheriting an IRA, a spouse can roll over the IRA into their own IRA. However, if the client will need to take distributions and is under the age of 59.5, the advisor should consider having the client keep the account in an inherited IRA in order to avoid the additional 10% penalty.

The 10-Year-Rule

The IRS released proposed regulations Feb. 23 that have caused some confusion for advisors and their clients, particularly around the new 10-year rule. If the proposed rules go into effect, it is possible that some beneficiaries who inherited an IRA in 2020 and did not take a distribution in 2021 may have missed their RMD and potentially be subject to a 50% penalty. The hope is that if the proposed rules go into effect, that the IRS will provide some relief due to the confusion.

If a beneficiary is not considered an eligible designated beneficiary, the stretch IRA option is eliminated and the 10-year rule applies instead. The rule states that all of the funds in the inherited IRA must be withdrawn by the end of the 10th year after death of the original account owner. However, a key distinction is made if the account owner died before or after their required beginning date. If the IRA was inherited before the required beginning date, the beneficiary does not have an RMD, as long as the account is depleted by the end of the 10th year after death. However, if the account owner dies after their required beginning date, the beneficiary must take RMDs in years one through nine after death and must withdraw the balance by the 10th year. They do not need to take out as much as the original account owner, since they can use their own life expectancy.

Example 1

Susie, age 30, inherits an IRA from her father in 2022. Her father died prior to his required beginning date. Susie can take out any amount from her IRA, including zero from years one through nine, and must deplete the funds in the account in year 10. This allows for a planning opportunity since she can control the withdrawals up to the 10th year.

Example 2

Sallie, age 45, inherits an IRA from her mother in 2022. Her mother died after her required beginning date. Sallie must take at least the required minimum distribution years one through nine and must deplete the funds in the account by year 10. This also allows for a planning opportunity but is not as favorable since distributions are required during years one through nine.

The 5-Year Rule

If the decedent did not have named beneficiaries on the IRA and died prior to their required beginning date (this includes Roth IRAs since they do not have an RBD), non-designated beneficiaries such as a charity, an estate, or a non-qualifying trust will be subject to the 5-year rule. Under this rule, the account must be distributed by Dec. 31 of the year that contains the fifth anniversary of the original IRA owner’s death. Distributions can be made, but are not required, in years one through four.

Roth IRAs

Although still subject to the 10-year rule, Roth IRAs are not subject to required minimum distributions and therefore do not have a required beginning date, regardless of the age of the account owner at the time of death. However, the account balance must still be depleted by the 10th year for all designated beneficiaries. For non-designated beneficiaries, the 5-year rule will apply.

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