Non-eligible designated beneficiaries have 10 years to draw down inherited qualified retirement accounts; here, we explore ways to extend the life of that wealth.
With the recent finalization of the 10-year rule for IRAs, introduced by the SECURE Act, beneficiaries of qualified retirement accounts now need to think more strategically about what they’re inheriting.
“Historically, the strategy was simple: owners would put as much money as they could into qualified accounts, because beneficiaries could then roll those funds into inherited IRAs and take distributions over their life expectancies,” says Jim Kidney, CPWA®, who supervises the financial planning consulting practice at Raymond James. “Then the SECURE Act comes along, and what could’ve been payments over multiple decades is now payments over one.”
The rule requires that non-eligible beneficiaries – broadly, non-spousal beneficiaries of an account – deplete the funds inherited from a qualified account within 10 years of the owner’s passing.
But even with the addition of a countdown clock, there are ways for beneficiaries to make the most of the time they have.
As we covered in another recent article on the 10-year rule, it applies differently to different beneficiaries. There are two overall categories: eligible designated beneficiaries and non-eligible designated beneficiaries. For the eligible set, the rule doesn’t actually change much. Most can still open an inherited IRA and elect to take distributions over their life expectancies, with children being eligible until they reach 21, at which point the 10-year rule kicks in.
For non-eligible heirs, however, the 10-year rule is universal, but the way in which distributions can or must be taken differs.
If an account owner passes away before reaching their required beginning date, the day they must take their first RMD, a beneficiary has more distribution flexibility. They can elect consistent or graduated distributions over all or some of the 10 years. Or, they can take a lump sum in the 10th year.
In cases where an account owner has already taken one or more RMDs before death, the beneficiary must also take RMDs. They can elect to take more than the minimum, but the RMD must be taken each year.
There’s also the most clear-cut option: An heir could opt to take a lump-sum payment in lieu of opening an inherited IRA with the funds. For substantial accounts, however, this would generate a significant tax bill and is generally to be avoided.
Planning, Jim says, is now a critical factor for beneficiaries. “Things have gotten much more complex. It’s really important for all the parties involved to be aware of the requirements and to have strategic discussions that include professional advisors.”
Jim also emphasizes the outsized role taxes play in these situations.
There are some steps account owners can take pre-emptively to benefit their heirs, like converting a traditional IRA to a Roth account and paying taxes up front so beneficiaries can inherit the account tax-free, if certain criteria are met. But once a qualified account changes hands, strategic timing becomes key.
Beneficiaries are often in their prime earning years and sitting in the attendant higher tax brackets, so taking larger distributions or a lump-sum could launch them into an even higher one.
If a beneficiary’s tax picture is unlikely to change much in the coming years, one option would be for them to take distributions proportionally over the 10-year window – in the first year, take one-tenth, then one-ninth, then one-eighth, etc.
Those closer to retirement might consider taking the minimum distribution or, if it’s an option, taking nothing while they’re still working, and then once they retire, begin taking distributions or begin taking larger ones.
Whatever the strategy, having one is now an important part of the conversation. And having conversations, Jim says, especially those between account owners and their beneficiaries, is crucial.
Today’s beneficiaries are tomorrow’s benefactors. And what they’re learning about the process of inheriting an asset like this now, can be used to help set their own heirs up for success.
“It’s about being more mindful of what you’ll be passing along,” Jim says. “The chairs have been rearranged to a degree, so it’s important to take the time to think about what you want for your heirs and plan accordingly.”
One area where he recommends extra deliberation is who an account owner names as their beneficiary in the first place.
People typically name a spouse or significant other. In the case of a large IRA, a more strategic approach would be to split things up, leaving 80% to a spouse and 20% to children, for example. The spouse could then name the children as their beneficiaries and potentially extend the account’s life across two 10-year clocks.
A potential beneficiary’s tax position is also important. For example, if an account owner has heirs in different tax brackets, those in the lower bracket might be better candidates to inherit a large IRA.
“The worst thing you can do here is ignore it,” Jim says. “It’s important as an owner and as a beneficiary to consider this as part of your overall finances and to have a plan.”
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Raymond James does not provide tax or legal advice. Please discuss these matters with the appropriate professional. Withdrawals from tax-deferred accounts may be subject to income taxes, and prior to age 59.5 a 10% federal penalty tax may apply.
Converting a traditional IRA into a Roth IRA may involve additional taxation. When converted to a Roth, you pay federal income taxes on the converted amount, but no further taxes in the future. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Each converted amount is subject to its own five-year holding period, unless the owner is 59.5 or older.
