Have you checked the beneficiary designation for your IRA or 401K plan lately? Major changes occurred in 2019, when the SECURE Act rewrote the terms for distributing funds from retirement accounts to beneficiaries upon the owner’s death. Here are some concerns to consider.
Under prior law, the named beneficiary could stretch the payment of retirement funds over their lifetime. The SECURE Act limited those who can stretch the payment to a few classes of people. All others must transfer their inheritance from the inherited IRA within ten years. Most beneficiaries are subject to the 10-year rule when inheriting IRAs, Roth IRAs and retirement accounts such as 401(k)s unless they are an “eligible designated beneficiary”. The 10-year rule only says that the inherited retirement account must be completely distributed by the end of the tenth year after the year of death.
Spouses are exempt from the new 10-year rule created in the SECURE Act. The surviving spouse of a deceased IRA owner retains the use of all the options in the code that existed before the SECURE Act. If the surviving spouse opts to use the life expectancy payout, upon the inheriting spouse’s death the exception ceases to apply and the account must be empty by the end of the tenth tax year after the year the beneficiary dies. In addition, a designated beneficiary, not more than 10 years younger than the IRA owner, perhaps a sibling, may also stretch payments out over their lifetime.
Another exception to the 10-year rule is for “eligible designated beneficiaries (EDB).” In addition to spouses, beneficiaries that qualify as an EDB can still utilize the “stretch” option for taking distributions. The stretch option allows a beneficiary to spread distributions over the beneficiary’s remaining life expectancy subject only to an annual Required Minimum Distribution (RMD).
After 2019, eligible designated beneficiaries are minor children, disabled beneficiaries, chronically ill beneficiaries, or a beneficiary not more than 10 years younger than the deceased.
As to minor beneficiaries, upon reaching majority, the 10-year rule applies and the account must be empty by the end of the tenth tax year after the year the beneficiary reaches the age of majority.
Disabled beneficiaries are those who meet the description in Section 72 (m)(7) of the tax code. The same is true as to chronically ill persons as described in Section 7702B (c)(2) of the Code. In the case of a disabled or chronically ill person, the best planning is to name a trust as the beneficiary. The trust will be for the benefit of that disabled or chronically ill person. For payout purposes, the trust will be treated as if an eligible designated beneficiary.
For income tax purposes, the trust receiving retirement benefits for the eligible designated beneficiary should be treated as a qualified disability trust. With qualified disability trusts, under Section 642(b)(2)(C) of the tax code, the personal exemption amount can be applied to reduce income tax. To the extent that funds are distributed to the beneficiary, those dollars are taxed to the beneficiary at the beneficiary’s income tax rate, which is presumptively lower than the trust tax rates.
If you are wondering why the change in distribution rules for qualified retirement plans the answer is to improve revenues for the government. Raising taxes isn’t the only way for the federal government to improve revenues. By accelerating the payout of funds, the United States government hopes to raise tax dollars faster and in higher amounts.
Retirement accounts are often the largest asset in an estate. Careful planning is important to reduce taxes, especially when the beneficiary is disabled or chronically ill.
Evan J. Krame