The IRS Assumes a Final-ish Posture on the SECURE Act
It is safe to say that, for most, season three of FX’s seismic series The Bear was July’s most highly anticipated new release, but perhaps the IRS’ latest clarifying entry in the SECURE Act bears our collective consideration. While surely less appetizing to sink your teeth into than a dish whipped up on the Emmy award-winning show, 2019’s SECURE Act (Setting Every Community Up for Retirement Enhancement) and 2022’s SECURE Act 2.0 signaled a significant shift in the cadence beneficiaries must follow in distributing inherited retirement accounts. Now, with the Final Regulations (issued July 17) on the table, you would not be expected to spend a weekend sampling seemingly endless pages of tax jargon to make it all make sense. Devote that valuable time to binging must-see television, but first, here are the key takeaways you’ve been hungry for. Let’s dig in.
PREVIOUSLY ON…
Prior to the SECURE Act, those who inherited tax-deferred accounts had several favorable options for distributing, such as spousal rollovers or stretching the required minimum distributions (RMDs, calculated annually based on an age-dependent formula) over the greater of their life expectancy or the decedent’s remaining life expectancy. If you inherited during this time (pre-2020), the guidelines remain unchanged.
SECURE’s first iteration and the 2.0 edition removed the stretch rules for many non-spouse beneficiaries from 2020 onward and ushered in a tighter ten-year timeline in which the account must be withdrawn in full, which begged a host of questions. When exactly does the new ten-year rule apply? Do RMDs have to be made along the way? Do the guidelines vary if the beneficiary is a trust or if post-tax (Roth) monies comprise the entire account? The IRS provided answers: sometimes, not really, it depends.
In response to this ambiguity, the past few years of RMDs for inheritors were waived. The latest regulations set the scene for a clearer path forward when applicable distributions are set to resume in 2025.
BEAR WITH ME
To figure out what rules apply to you as the primary beneficiary of tax-deferred funds inherited on or after January 1, 2020, there are three key ingredients. (Yes, we are really sticking with The Bear culinary analogy.)
- From whom did you inherit?
- Was the decedent at or beyond their required beginning date (when RMDs kick in)?
- Did you inherit outright or in trust?
Ingredient 1: Assume first that you are an individual who inherited the retirement account outright. SECURE classifies you as either an eligible beneficiary (surviving spouses plus a few additional exceptions) or a non-eligible beneficiary (most non-spouse individuals). Eligible beneficiaries also include minor children of the original owner (under 21), disabled or chronically ill persons, or inheritors less than ten years younger than the decedent.
Whereas non-eligible beneficiaries must now deplete within ten years of the date of passing, eligible beneficiaries have more options, including the advantageous stretch timeframe or a spousal rollover to their own IRA.
Ingredient 2: Did the previous owner begin Required Minimum Distributions during their lifetime? The mandated age has been amended several times in the past few years. Currently, it is set at age 73, though in the last five years it has increased from 70.5 to 72, then 72 to 73. It is scheduled to move again to 75 in 2033. Depending on whether or not the previous owner had reached RMD age is a major determinant in your requirements as a beneficiary.
If your head is spinning, fear not. Like any good recipe, we have pictures.
IRA Owner Died In/After 2020 & Before RMD Age:
IRA Owner Died In/After 2020 & After RMD Age:
Ingredient 3: This is the juncture where we elevate beyond mere home cooking and strive for a Michelin star. If a retirement account names a trust as its primary beneficiary and you are the beneficiary of that trust, the implications may be quite different. An estate planning attorney is your sous chef and will be able to identify if the trust is classified as a “see-through trust” or not.
See-through trusts are required to pay out to beneficiaries (or custodial accounts for the benefit of a beneficiary) and can take advantage of the ten-year rule or stretching distributions for those deemed as eligible beneficiaries, provided there are not multiple named beneficiaries including someone who is non-eligible; in that instance, the ten-year rule applies to all.
Trusts that are not see-through have only five years to empty the retirement account and the net funds accumulate and are taxed within the trust. For both types of trusts, intra-timeline RMDs depend on whether or not the original account owner had reached their required beginning date.
To top it all off, if an inheriting trust divides further into separate trusts, each may follow a different rule depending on the classification of the beneficiaries of each.
The below flow chart illustrates ten years versus five, though keep in mind that stretch rules may be an option for see-through trusts paying out to eligible beneficiaries.
SUBTLE NOTES OF FLAVOR
Timing: The clock for distributing starts the year following the date of death. If the previous account owner was past RMD age, 2025 is the first year the inheritor must take a distribution. We anticipate custodians will have guidelines to assist with calculating the appropriate amount. No retroactive distributions are required (say from 2021-2024) and there is no penalty for the years that were disregarded.
Annuities: Should an inherited IRA hold an annuity contract that is paying out, those payments can be included in the calculated RMDs (if applicable) and must cease when the inheritor’s distribution timeline is complete.
Roth: Inherited Roth IRAs or retirement accounts that were funded with 100% post-tax funds will need to be distributed in the same spans of time (stretch, ten-year, or five-year), but no annual RMDs along the way will be required. If practical for one’s financial situation, it is a good practice to let the funds accumulate in these Roth accounts, tax-free, for as long as possible. You cannot directly roll the balance into another Roth IRA, but you can withdraw all principal and earnings with no income tax due at the end of the period.
Minors: Minor beneficiaries veer from eligible to non-eligible when they reach age 21, and the age of majority under state law is irrelevant. While they are considered eligible (under 21), they must take stretch distributions based on their life expectancy. Then, the ten year clock starts ticking on their 21st birthday, and they must take RMDs during that window regardless of at what age the original account owner passed away. Note that if an original owner leaves their retirement savings to a grandchild, the grandchild is not considered eligible and therefore starts a ten-year clock from the onset.
Successor Beneficiaries: A different set of guidelines apply to successor beneficiaries. For simplicity’s sake, if stretch distributions were permitted for the primary beneficiary, the successor must pivot to the ten-year rule, whereas a successor jumping in partway through a primary’s ten years will be expected to take over and complete that period currently in progress.
TASTE TEST
The knee jerk reaction to SECURE’s more stringent requirements may be frustration as we collectively try to decipher the prescribed path forward. But there are planning opportunities that you still have plenty of time to implement. Should you be the beneficiary of an inherited account which will require you to take a distribution in 2025, you have a year to proactively plan ahead for that bump in taxable income. Also, even though you do not need to withdraw in 2024, you certainly could in an effort to further spread out taxes that will eventually be due.
Take a moment to revisit the beneficiaries named on your retirement accounts. Unless an inheriting trust is carefully constructed with an estate planning attorney to be a see-through trust, it may be more tax-efficient (and easier practically) to name your beneficiaries outright so they have more time to distribute at their income tax rates instead of trust rates. You may also consider passing different types of accounts to different beneficiaries. For example, if you wish to leave retirement assets to your children, they may inherit at a stage in their life where they are employed and being taxed at higher rates. Pre-tax savings could flow strategically to beneficiaries who may be in lower tax brackets and your Roth bucket could be bookmarked for those in higher brackets. Careful planning can be done to map out equal net amounts to each beneficiary with the least amount of your hard-earned retirement savings claimed by the government.
You can also consider naming a 501(c)(3) charity as the beneficiary of your pre-tax assets, and they can distribute the full balance without owing any income taxes. A Donor Advised Fund established during your lifetime can also inherit with no tax due and a named successor can continue your legacy. IRAs are often the first place to start when it comes to testamentary giving.
Any alteration to tax provisions comes with a lot to digest, but also an opportunity to revisit planning, inventory your assets, and infuse a fresh sense of intentionality in your beneficiary structure. President Eisenhower emphasized post-WWII that “plans are worthless, but planning is everything.” No financial plan is frozen, but by taking the time to recalibrate with each ingredient life or the IRS mixes in, the very act of thoughtful planning will surely bear fruit.