There’s almost always a reckoning when the government proffers a tax break. And so it is with individual retirement accounts (IRA)s, 401(k)s and similar accounts that investors fund with pre-tax earnings.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 reset the gameboard for IRAs and similar accounts (I’ll refer to them collectively as “IRAs” in the rest of this article).
Investors, you’ll remember, pay ordinary income tax on withdrawals—voluntary or required minimum distributions (RMDs)—from IRAs (except for Roth IRAs; we’ll get to those). When people have stopped working, they often pay lower income tax rates. Life is good.
The SECURE Act, however, changed the guidelines for the payout of IRAs and similar accounts if an account owner dies with assets in the accounts. Beneficiaries who are not spouses of the account owner now have 10 years to empty the accounts—setting them up for potentially large tax bills, maybe in years when their ordinary income tax rates peak.
Altogether, the situation puts the onus on financial advisors to inform their clients and help them plan for future scenarios in which they and their families may find themselves.
Inherited IRAs And Beneficiaries: Scenarios And Options
Investors or couples with significant IRAs and brokerage assets are the most likely to face the consequences of the new tax regulations for RMDs and inheritance from the SECURE Act.
A widowed spouse inheriting a partner’s IRA faces the lower of a) the spouse’s or b) the partner’s RMD rate (tied to birth years). More significantly, though, a widowed spouse files as a single tax return, not a joint one—halving available deductions and tax brackets.
The lesson is: Whether single or married, clients should consider accelerating IRA withdrawals when their taxable income wanes early in retirement. Tapping IRAs voluntarily in those years also can mean they defer (and therefore optimize) Social Security benefits to age 70.
Non-spouse beneficiaries of inherited IRAs—often adult children—have 10 years to empty those accounts. The beneficiaries’ tax rates will depend on how much they earn, whether they file single or joint returns, and the deductions available. If a beneficiary dies while the account still has assets, those assets could be subject to estate taxes (at very high rates).
The lesson is: Estate planning is essential in this scenario. IRA owners may want to “equalize” inheritances among heirs in ways other than dividing assets evenly. For example, investors may want to make a child with lower taxable income the beneficiary of the IRA and another child with higher earned income the assets of brokerage accounts or Roth IRAs. Or IRA owners may want to establish trusts or make charitable bequests to empty IRAs before they can become part of an estate.