Want To Leave Your Kids An Inheritance? They May Only Have 10 Years To Take It.

The Secure Act, which was signed into law in December 2019, brings about several major changes to the retirement system. One such shift marks the end of so-called “stretch IRAs” for non-spouse beneficiaries who inherit a retirement account after 2019. Although there are a couple of exceptions, starting in 2020, most adult children inheriting an IRA or other type of retirement account from a parent will only have 10 years to drain the account.

Individuals who inherit a retirement account from a parent only have 10 years to take the money

Before the passing of the Secure Act, most non-spouse beneficiaries who inherit any type of IRA, or a defined contribution plan such as a 401(k) or 403(b) can choose to withdraw the funds by taking required minimum distributions (RMDs) over their lifetime. Beneficiaries would calculate their life expectancy according to their current age in the IRS’ uniform lifetime table. Due to this ‘lifetime distribution’ option, this was commonly called a ‘stretch IRA’.

However, following the passing of the Secure Act, adult children who inherit a retirement account from a parent or relative will no longer be able to take distributions over their lifetime if the decedent passed away after January 1^st, 2020. These inheritances will now need to be depleted by the end of the 10^th year following the passing of the parent/relative. 

There are three exceptions to the 10-year rule. Minor beneficiaries will have until they reach the age of majority (age 18 to 21 depending on the state) before the clock starts ticking on the 10-year payout period. The 10-year distribution rule will not apply to beneficiaries less than 10 years younger than the decedent or if the beneficiary is disabled. These beneficiaries could withdraw the funds over their lifetime using the current rules.

Again, these changes do not impact individuals who inherited a retirement account from a non-spouse (e.g. parent or relative) who passed away during or prior to 2019 or inheritances left to a spouse.

Legacy planning under the Secure Act

If this isn’t how you envisioned leaving an inheritance to your children or grandchildren, you may want to consider some alternative planning opportunities during your lifetime. Once your pass away, your beneficiaries won’t have many options available to them other than to take the funds by the end of the 10-year window.

Some planning opportunities for account owners may include:

• A Roth conversion: converting funds from an old 401(k) plan or a traditional IRA to a Roth IRA won’t help your heirs extend their payout period beyond 10 years, but it can help them avoid realizing large sums as ordinary taxable income. Provided beneficiaries wait at least five years after you first funded the Roth IRA, distributions will be tax-free. Keep in mind, converting pre-tax money to a Roth IRA means you will recognize the amount in your ordinary income for the year. If you’re in a high marginal tax bracket or still working, this may not make sense.
• Leave taxable assets in a revocable trust instead: These changes only apply to inherited retirement accounts, not regular taxable investment accounts. To avoid probate, consider bequeathing assets in a taxable brokerage account to heirs through a revocable trust, also called a living trust. Under current tax law, assets will receive step-up in cost basis to the fair market value as of the account owner’s date of death. While tax will be due on any subsequent capital gains or dividends received, there is no requirement to withdraw the funds.
• Review existing trust payout terms: Speak with your estate planning attorney to understand how the new law may change your existing strategy and if changes should be considered. For example, if you named a trust as the beneficiary of your IRA and the payment terms indicate that only required minimum distributions can be distributed, this could mean beneficiaries are only entitled to receive a lump sum in year 10 under the Secure Act, a situation some are calling a ‘tax bomb’.
• Consider a charitable remainder trust: At a very high level, here’s how it works: a charitable remainder trust (CRT) is established and named the beneficiary of a retirement account. The beneficiaries of the CRT are your adult children. The charitable remainder trust could make payments to your kids for up to 20 years before the remaining assets were distributed to the charity you selected. There is a cost to set up and administer this type of trust, and it won’t be right for everyone, so be sure to discuss the pros and cons with an estate planning attorney in your area.

Carefully weigh your options with your financial advisor, estate planning attorney, and tax advisor before making any changes to your situation and be sure to fully understand the pros and cons.

Keep in mind, these strategies could also fall victim of new legislation in the future, with or without grandfathering. So it’s important to weigh your goals with the risks and opportunities.

Options for beneficiaries inheriting a retirement account from a parent

Starting in 2020, adult children who inherit a retirement account may have little opportunity to avoid the escalation of the recognition of taxable income, which can significantly impact their tax situation. This is particularly true for individuals in the prime of their earning years.

As previously mentioned, once the account has passed onto the beneficiaries, the planning options are currently limited. Here are several important things to note:

• Rules for inherited Roth IRAs: If it’s been at least five years since the original account owner first funded the Roth IRA, distributions to the beneficiary will be tax-free. While the beneficiary of a Roth IRA may not be impacted from a tax perspective, they still need to take the funds by the end of the 10^th year.
• No RMDs: There are no distribution requirements during the 10-year period, so you could take it all during year 10 if you wanted, but consider working with your CPA and financial advisor to develop a plan.
• No Roth conversions: Non-spouse beneficiaries could not convert an inherited retirement account to a Roth IRA before the Secure Act. The new legislation does not change this.  
• Reinvesting your inheritance: After-tax proceeds can be reinvested in a brokerage account and used down the road for long-term financial goals. Keeping the funds invested can help curb sharp increases in lifestyle spending, which is most tempting when funds are highly visible or sitting in a checking or savings account.

We plan, God laughs

As you consider what modifications (if any) to make to your legacy or estate plan, remember to focus on what you can control. The major changes included in the Secure Act follow numerous other shifts in tax law from the Tax Cuts and Jobs Act at the end of 2017. In the current political environment, more changes to the tax system could be on the horizon, which is something to keep in mind as you weigh the cost, benefits, and potential future flexibility of new planning strategies.