What you need to know about beneficiary IRAs in 2020
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The Secure Act has brought with it some new rules for those lucky enough to receive an inheritance in the form of a beneficiary IRA. These rules will change how long you have to move money out of your beneficiary IRA, which could dramatically increase the taxes you end up paying on your inheritance. Keep reading for what you need to know about the new beneficiary IRA rules in 2020.
I have spoken to many people who have been given conflicting information, in regard to the new rules around the beneficiary IRA. One recent client, in particular, received a different answer every time she called the 1-800 number of the giant mutual fund company that held the IRA she was inheriting. It pays to do your due diligence and work with a trusted financial planner; mistakes with beneficiary IRAs can be costly. Initially, she was told she couldn’t do a stretch IRA, which would have increased her tax liability on her beneficiary IRA by hundreds of thousands of dollars.
The Old Beneficiary IRA Rules
Before changes were made to the beneficiary IRA rules, those who inherited an individual retirement account were required to make a withdrawal from the account each year. The amount of those withdrawals was based on the heirs’ ages, and they could stretch the withdrawals over their own lifetimes. Doing so meant that the funds could benefit from tax-deferral for decades, depending on the beneficiary IRA owner’s age. Stretching out the withdrawal allowed owners of the beneficiary IRA to often pay much less in taxes than if they were forced to make larger withdrawals in any given year. Like withdrawals from a traditional IRA or 401(k), distributions from a beneficiary IRA are taxable.
New Beneficiary IRA Withdrawal Rules In 2020
Thanks to the Secure Act and the new beneficiary IRA rules, many people who inherit IRAs will have just 10 years to withdraw all the money from their beneficiary IRAs and pay the required taxes along the way. This could force those inheriting a large IRA or 401(k) to pay substantially more in income taxes than if they were allowed to use a stretch IRA under the old rules. Withdrawing the funds over just 10 years also means that the owner of the beneficiary IRA will have less time to benefit from the tax deferral on IRA assets.
There is some good news for those who already have a beneficiary IRA. The new rules (under the Secure ACT) only apply to retirement accounts inherited after Dec. 31, 2019. In plain English, heirs, of IRA owners who died in 2019 (or earlier), are still allowed to use the stretch IRA approach with their beneficiary IRAs.
There Are Exceptions to The Beneficiary IRA Rules
All is not lost for those who inherited an IRA, 401(k), or another retirement account. You are still able to use the stretch IRA strategy to minimize income taxes on your inheritance. If you are a spouse inheriting an IRA, you are able to rollover the IRA to an account in your name, with required minimum distributions (RMDs) that are based on your life expectancy. Minor children, who inherit an IRA, can leave the money in a beneficiary IRA until they reach the age of 18 or 21, depending on their state. From there, the ten-year clock begins to withdraw all funds.
There are a few further exceptions to the new Secure Act Beneficiary Rules. For example, people with disabilities and those with chronic illnesses who inherit retirement accounts that are eligible to be turned into beneficiary IRAs are exempt from the ten-year withdrawal deadline. Similarly, a beneficiary who is less than 10 years younger than the deceased account owner — think sibling, life-partner, or non-married significant other — can also continue to “stretch” the beneficiary IRA. The rules here are very specific, as well as the IRS deadlines that must be met. Discuss this with your fiduciary financial advisor to make sure you avoid making a costly beneficiary IRA mistake.
In 2020, the new beneficiary IRA rules apply to both traditional IRAs and Roth IRAs. The rule also applies to both pre-tax and post-tax 401(k) workplace retirement accounts.
The new beneficiary IRA rules don’t take effect until 2022 for 403(b) and 457(b) plans, which are generally available to government and nonprofit workers; and the federal Thrift Savings Plan (TSP), which is the retirement program for federal employees. Beneficiaries inheriting one of those accounts in the next two years can still use the stretch option.
There is a bright side to the new rules. With the stretch IRA option, you would be required to take out a certain amount each year from the beneficiary IRA. These required withdrawals are commonly known as required minimum distributions (RMDs). Under the new rules, you have a ten-year period to move all of the money out of the beneficiary IRA. This may allow you to be strategic about when you make a withdrawal. For example, an heir may decide to withdraw more money during years with lower income or wait until retirement, if that makes sense. Since we are talking about 2020, with millions of Americans out of work, this year might be a good year to make larger withdrawals, assuming you had a smaller income. On the flip side, someone might decide to wait until the final year to pull the entire account balance, which could push them into higher tax brackets than is absolutely necessary and force them to pay significantly more taxes.
If you are lucky enough to receive an inheritance, take the extra time to set up a beneficiary IRA to help improve your own financial future. Making smart choices with this money can help you have a happier, healthier, and wealthier retirement. At the very least, with your financial planner, you can implement a plan to minimize the taxes you pay on your beneficiary IRA while allowing the investments to grow over time.