FAQ: Understanding the ‘Stretch IRA’ after the SECURE Act
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The Setting Every Community Up For Retirement Enhancement Act, better known as the SECURE Act, made significant changes to the rules for post–death distributions from individual retirement accounts.
With a few exceptions discussed below, beneficiaries of traditional individual retirement accounts and other qualified plans, including 401ks (hereafter referred to generally as “IRAs”) now must withdraw the balance of an inherited IRA within 10 years of the plan participant’s death. Generally, the new rules apply to distributions from IRAs inherited from participants who died after December 31, 2019.
Read on to learn more about how the SECURE Act will affect beneficiaries of retirement accounts and what plan participants should consider.
What was a ‘Stretch IRA?’
Before the SECURE Act, a beneficiary who inherited all or a portion of an IRA generally was required to withdraw a minimum amount annually, calculated using the beneficiary’s life expectancy. Withdrawals are subject to income tax as the beneficiary receives them, whereas assets that remain in the IRA continue to grow tax deferred. Therefore, by withdrawing only the minimum amount each year, the beneficiary could “stretch” the tax deferred growth over his or her lifetime. Hence, the term “stretch IRA.”
What changed under the SECURE Act?
The SECURE Act limits the types of beneficiaries who are eligible for the stretch. Unless the beneficiary was the plan participant’s spouse or falls under one of the other categories noted below, the beneficiary now must withdraw the entire balance of an inherited IRA within 10 years of the original owner’s death.
For example, consider a plan participant who named his daughter as the sole beneficiary of his IRA. If the participant died in December of 2019 (pre-SECURE Act) when his daughter was 40 years old, the daughter would have been eligible to withdraw the IRA in small installments over 43.6 years. On the other hand, if the participant died in January of 2020 (post-SECURE Act), the daughter would be required to withdraw the entire IRA within 10 years. The accelerated payout results in a shortened period of tax deferred growth and an increased amount of taxable income to the daughter over the 10-year period.
Who can still use a ‘Stretch IRA’ under the SECURE Act?
The SECURE Act carves out five specific categories of beneficiaries who still are eligible to stretch distributions from an inherited IRA beyond 10 years. The categories include:
- Surviving spouse of the plan participant
- Minor child of the plan participant
- Disabled individual
- Chronically ill individual
- Beneficiary who is less than 10 years younger than the plan participant
Special rules govern the minimum distributions for each type of beneficiary. For example, a surviving spouse may “roll over” an inherited IRA into an existing or new IRA of his or her own, which permits the spouse to defer all distributions until he or she reaches age 72 (formerly 70 ½, before the SECURE Act) and then to qualify for a minimum payout based on the spouse’s life expectancy.
A minor child of the plan participant is eligible for a life expectancy payout until the child reaches the age of majority (18 in most States), after which the 10-year rule applies; however, the postponement of the 10-year rule is not available to other minors, such as the participant’s grandchildren. Disabled beneficiaries, chronically ill beneficiaries and beneficiaries less than 10 years younger than the plan participant qualify for the life expectancy payout.
What if you inherited an IRA before January 1, 2020?
As noted above, IRAs inherited from plan participants who died before January 1, 2020 can still qualify for a stretch. However, the SECURE Act may not have spared pre-2020 inherited IRAs completely.
Before the SECURE Act, upon the original beneficiary’s death, his or her own beneficiaries were eligible to continue minimum distributions based on the original beneficiary’s life expectancy. Although further clarification is needed from the government, the SECURE Act implies that a subsequent beneficiary who inherits from the original beneficiary after December 31, 2019 will be subject to the 10-year rule. Therefore, original beneficiaries of pre-2020 inherited IRAs should take this into account when designating beneficiaries of their own.
What should IRA plan participants do now?
IRA plan participants should review their beneficiary designations and analyze how SECURE may affect the required post–death payout.
If long–term tax deferral was the driving force behind the selection of a beneficiary (for example, a grandchild), the participant may want to consider alternatives. Converting the account to a Roth IRA, under the right circumstances, can minimize taxes. If the plan participant is charitably inclined, it may make sense to designate one or more charities as the beneficiaries. Alternatively, a Charitable Remainder Trust can provide benefits to charity and to family members, while achieving income tax deferral similar to that of a stretch IRA.
Contact me or another member of Kaufman Rossin’s estate and trust tax team to review your options and discuss any potential changes to your retirement accounts post-SECURE Act.
