By Steve Doster
A new federal law called the SECURE Act went into effect this year that impacts everyone with an IRA or employer savings plan including 401(k), 403(b), and TSP. This new packet of changes mostly impacts the heirs who will inherit these accounts. Grandparents and parents will be most interested in these changes because passing along investments to younger generations is an important goal for them.
Before getting into the specific changes, we need a crash course in “required minimum distributions,” or what many people call RMDs. The government created rules that allow us to save in pre-tax retirement accounts. This is great! We can save in accounts like IRAs and 401(k) plans without paying taxes on that saved money. This allows more of your savings to be invested because you didn’t have to pay taxes on that money.
Of course, the government eventually wants their share of the pot! The IRS requires you to take distributions from these pre-tax accounts at a certain age. These required minimum distributions, or RMDs, make pre-tax money pass through the tax gate so the IRS can collect their taxes. RMDs require people to take money from these pre-tax accounts as a way to create tax revenue from your retirement savings. The government won’t allow you to let this money grow tax-free forever.
This brings us to our first change in the IRA laws. Previously, people had to start taking RMDs from their IRA, 401(k), 403(b) and TSP plans when they turned 70.5 years old. This age was pushed back to 72 years old.
This is a good change for people who don’t need their retirement savings to live on. They can delay the start of RMDs by 18 months.
The big changes to your IRAs occur after you die. Under the previous rules, non-spouse beneficiaries who inherited IRAs and employer plans could “stretch” their RMDs over their lifetimes. This was called a “stretch” IRA. A typical scenario is this: parents die and the kids inherit the IRAs; the kids could take RMDs over their lifetimes and let the IRAs continue to have tax-deferred investment growth. This also limited the tax liability for the kids because they were only required to take out a small distribution of the IRA each year.
The new law no longer allows kids (or any non-spouse beneficiary) who inherit IRAs to stretch their RMDs over their lifetime. Non-spouses who inherit IRAs now must withdraw the entire IRA balance within 10 years of inheriting the money. This 10-year rule also applies to inherited Roth IRAs.
This is a gigantic change in the rules! It allows the IRS to collect billions in tax revenue over a short period of time as parents pass away and wealth transfers to their kids and other heirs.
As with all things in life, there are exceptions! If you already have an inherited IRA from before 2020, you are grandfathered in and can continue to take your RMDs over your lifetime. The new 10-year rule does not apply to you and things will continue as they have in previous years.
Additionally, the 10-year distribution rule does not apply to a surviving spouse. The old rules for married couples are still the same. If your spouse dies, then you can take their IRA into your own name and there are no required minimum distributions until you turn 72 years old.
Another exception to the 10-year distribution rule is non-spouse IRA beneficiaries who are no more than 10 years younger than the original IRA owner. A probable case is a single person with no kids who has their siblings as their IRA beneficiaries. If the IRA owner dies, the siblings who are no more than 10 years younger than the IRA owner can stretch out the RMDs from the inherited IRA over their lifetime.
What if the siblings who inherit an IRA are older in this example? They cannot stretch out the RMDs over their lifetime. They must withdraw their inherited IRA within 10 years of inheriting the account.
One more exception to the new 10-year withdrawal rule are minor kids of the IRA owner. It’s important to note this is not for any minor kid who inherits an IRA, it is only for minor kids of the original IRA owner. In these situations, the minor child can “stretch” the required minimum distributions until they are 18 years old. Once they reach 18, the 10-year clock begins, and the adult kids need to withdraw all the inherited IRA money by the time they are 28 years old.
If the inheritor of the IRA is disabled or chronically ill, then the RMDs can be taken over the lifetime of the IRA inheritor. There are specific criteria to qualify for these exceptions. A financial advisor should help you in these situations.
These are just two of the new IRA rules. Pushing back the RMD age to 72 is a benefit for IRA owners. The other rule change requiring inherited IRAs to be fully withdrawn in 10 years is a revenue generator for the government and not a benefit for your heirs.
This rule change makes it extremely important to have an estate planning attorney review your living trust. The new rules create potential landmines in your estate documents. A review by your attorney will ensure that your heirs will receive the best tax treatment when they inherit your IRAs.
We still have more changes to cover regarding IRA contributions and qualified charitable contributions, but these will occur in next month’s article.
— Steve Doster, CFP, is the financial planning manager at Rowling & Associates – a fee-only wealth management and CPA firm helping individuals create a worry-free financial life. Rowling & Associates works to a fiduciary standard of care helping people with their taxes, investments, and financial planning. Read more articles at rowling.com/blog.