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Mistakes IRA Beneficiaries Are Making After the SECURE Act

Published on: Dec 17 2020

A year has passed since the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed Congress by a wide margin. Yet, many IRA beneficiaries don’t know about the law or are receiving bad information about it.

The SECURE Act made a major change for individual retirement arrangement (IRA) beneficiaries. Previously, someone who inherited an IRA could implement a Stretch IRA. This isn’t a special type of IRA. A Stretch IRA is a strategy in which the beneficiary leverages the IRA’s tax deferral by taking no more than the required minimum distributions (RMDs) for a number of years. That allows the IRA’s value to grow over time, increasing the after-tax wealth eventually available to the beneficiary.

But the SECURE Act abolished the Stretch IRA for most beneficiaries. Most IRA beneficiaries now are subject to the 10-year rule. The inherited IRA must be fully distributed within 10 years after the original owner passed away. The beneficiary can distribute the IRA on any schedule. All the money can be left in the IRA until the end of 10 years, or it can be distributed in any pattern over the 10 years. But the IRA must be fully distributed by the end of 10 years. Failure to distribute the IRA on time results in a penalty of 50% of the amount that was supposed to be distributed but wasn’t.

The SECURE Act applies to both traditional IRAs and Roth IRAs. Though a distribution from a Roth IRA isn’t tax-able, Congress still wants a beneficiary to distribute the Roth IRA within 10 years, perhaps hoping the distributions will be put into taxable investments and generate more revenue for the government.

The SECURE Act also applies to 401(k)s and other defined contribution accounts.People are making mistakes, because the 10-year rule of the SECURE Act doesn’t apply to all IRA beneficiaries. It is important to know the exceptions and what qualifying for an exception means for a particular beneficiary.

Pre-2020 beneficiaries.

Despite what many beneficiaries are being told, the 10-year rule applies only when the original owner of the IRA passed away after 2019. Beneficiaries who inherited IRAs before 2020 are grandfathered. They get to follow the old rules and continue to benefit from a Stretch IRA.

Someone who became an IRA beneficiary before 2020 usually was able to take RMDs from the inherited IRA based on his or her life expectancy. Anyone in that situation can continue the same RMD schedule that was in effect before the SECURE Act was enacted. Of course, the pre-2020 IRA beneficiary also has the option to take a distribution of more than the RMD at any time.

No designated beneficiary.

I regularly remind my readers to be sure that one or more individuals, and only individuals, are named as beneficiaries of their IRAs. To maximize tax deferral, an IRA must have what the regulations call a designated beneficiary, and only individuals can be designated beneficiaries.

An IRA doesn’t have a designated beneficiary when no beneficiary is named or the estate or a trust (with some exceptions) is named. A charity, corporation or other entity also doesn’t qualify as a designated beneficiary.The SECURE Act didn’t change the rules that apply when an IRA doesn’t have a designated beneficiary.

For these IRAs, the required distribution schedule depends on whether the IRA owner died before or after reaching his or her required beginning date for RMDs. For those who turned 70½ in 2020 or later, the required beginning date is age 72. For all others, the required beginning date is age 70½.

When the IRA owner died before the required beginning date, the five-year rule applies. The entire IRA must be distributed within five years. When the IRA owner died after the required be-ginning date, the IRA can be distributed as though the IRA owner still lived, using the owner’s remaining single life expectancy in the IRS’s life expectancy tables. Of course, the IRA can be distributed faster than required.

Surviving spouse as beneficiary. Surviving spouses who are IRA beneficiaries are excluded from the 10-year rule. Surviving spouses have the same options they had before the SECURE Act.

One option for a surviving spouse is to roll over the IRA to an IRA in the surviving spouse’s name. This can be either a new IRA or an existing IRA. This is known as a “fresh start” IRA because the surviving spouse can treat the IRA as though it always had been his or her IRA, without reference to the IRA of the deceased spouse.

In a fresh start IRA, the surviving spouse takes RMDs based on his or her age and names beneficiaries for the IRA, all without reference to the deceased spouse’s IRA.

Another option for the surviving spouse is to treat the IRA as a regular inherited IRA. The difference is that after the SECURE Act, the surviving spouse isn’t subject to the 10-year rule. The surviving spouse of an inherited IRA uses the old rules, which allow for a Stretch IRA with RMDs taken over the surviving spouse’s life expectancy.

For more details about a surviving spouse’s options and how to decide which to choose, see our July 2018 issue.

Eligible designated beneficiaries.

A new category of beneficiary after the SECURE Act is the eligible designated beneficiary (EDB). An EDB is a beneficiary who is exempt from the 10-year rule. A surviving spouse is an EDB.

Other EDBs are a minor child of the deceased IRA owner, a disabled or chronically ill beneficiary and a beneficiary who is not more than 10 years younger than the deceased IRA owner. Note that while a minor child is an EDB, a grandchild is not. In addition, a minor child only is an EDB for as long as he or she is under the age of majority in his or her state (18 in most states). Once the beneficiary reaches the age of majority, the 10-year clock starts running.

Suppose Max Profits named his eight-year-old son, Hi, as beneficiary of his IRA. When Max passes away, Hi can take RMDs over his life expectancy, until he reaches age 18, which is the age of majority in his state. From that point, the 10-year rule applies to Hi. That means Hi can have a Stretch IRA with a maximum 20-year life.

Remember, there are ways you can restructure your IRA so that beneficiaries reap benefits similar to or, in some cases, better than the Stretch IRA. See our March 2020 and April 2020 issues for details.

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