Even though the SECURE Act was signed in 2019, the IRS has just recently publicized its interpretation of the tax code, and the resulting changes to the way IRAs are inherited should propel financial planners to review all of their clients’ beneficiary designations, said Tim Steffen, director of tax planning with Robert W. Baird & Co.

“The SECURE Act has some pretty significant and important changes that affect all of us as advisors and planners and, frankly, as future retirees ourselves,” Steffen said in a presentation at this week’s Morningstar Investment Conference. “The issue we have with the SECURE Act is it came into law in December 2019 and a few months later the world changed. And everybody kind of forgot what the SECURE Act was all about. Things like Covid and market crashes and PPP loans and the CARES Act, all these things came into play and the SECURE Act was standing in the background saying, ‘Hey don’t forget about me, I’m kind of a big deal.’”

That big deal is once again in the crosshairs of the IRS, he said, and in March the IRS released its proposed language around the new tax code, which has language Steffen described as “clear as mud.”

More details may be forthcoming, he said, but in the meantime the changes to inherited IRAs are significant and require a thorough review with any client's pre-retirement planning in terms of their beneficiaries, and with any client who is the recipient of an inherited IRA when the owner died in 2020 or after.

New Rules For IRA Owners
For IRA owners, the SECURE Act increased the age for required minimum distributions (RMDs) to 72 from 70½. The required beginning date (RBD) can still be April 1 of the year after a client turns 72, but two RMDs would be required that year.

An exception to the new RMD age is employees who keep working past 72 (they can delay distributions for an employer plan until retirement). There is no change to the age for penalty-free early withdrawals, still 59½, or to the age for qualified charitable distributions, still 70½.

“Is it really that big of a deal? It actually kind of is because it leads to a few planning opportunities,” Steffen said. “The first one is what I refer to as the 'trough year' opportunity. There’s a window of time between when people retire—call it 65-ish or so, when wages stop and income falls off in most cases—and they start Social Security, where they have a lot more control over their taxable income. And now with the extension of the RMDs out a couple of years, you have an even bigger window of time for planning opportunities.”

Some of those planning opportunities include Roth conversions, recognizing capital gains, diversifying out of company stock that has a low cost basis or selling shares and taking advantage of a lower capital gain rate, he said.

“The other thing we get is a great opportunity for spouses who are inheriting a retirement account,” Steffen said, adding that there are two options for that spouse. The first is they can roll the inherited IRA into their own name and it’s treated as if it has always been their IRA (RMDs calculated with the uniform life table). Or they can keep it as a beneficiary IRA and don’t have to begin RMDs until the deceased owner would have turned 72 (RMDs calculated with the single life table).

“Where is the planning opportunity? When the deceased spouse is younger than the surviving spouse,” he said. “If the survivor rolls it into his or her own IRA, that person is going to be hitting RMDs when they turn 72. But if you leave it as the inherited IRA, you don’t have to take RMDs until the decedent would have been 72, which might give you a few extra years to delay taking money out.”

The inherited IRA can then be rolled over to the survivor’s name before the deceased would have turned 72, and the RMDs are based on the uniform life table, which could be more advantageous.

“So don’t automatically roll those retirement accounts into the survivor’s name,” Steffen advised. “That’s not always the best option.”

On the negative side of the change to the RMD, he said, is “non-designated beneficiary risk,” which refers to a beneficiary on an IRA who is not a living person, such as an estate, charity or certain trusts. If the account owner dies before their RBD and leaves the account to a non-designated beneficiary, it triggers what is called the five-year rule, Steffen said. This means the IRA must be liquidated by Dec. 31 after the fifth anniversary of the account owner’s death.

 

“With a longer wait now to that RBD, pushing it out a couple of calendar years, there’s a bigger risk that the owner is going to die before that beginning date, and therefore the account is subject to the five-tear rule,” he said. “If there’s one thing you take out of this session today, it is review all the beneficiary designations on your clients’ retirement accounts. If they have a non-designated beneficiary, most likely an estate or will, you need to fix that. There’s no reason to have that as a beneficiary designation. They can always come up with something better than naming their estate.”

New Rules For IRA Beneficiaries
Under the new rules, there are no changes to the treatment of non-designated beneficiaries, but significant changes to some designated beneficiaries, he said.

“Here’s where the SECURE Act has really changed things,” Steffen said. “Now within the designated beneficiary category, there’s a new term we have to learn. There are certain beneficiaries that are going to the eligible to maintain the old stretch IRA rules, and they are conveniently called eligible designated beneficiaries. They are allowed to keep the old rules that we’ve always talked about.”

Eligible designated beneficiaries (EDBs) include spouses, minor children of the IRA owner, disabled or chronically ill beneficiaries, and beneficiaries who are less than 10 years younger than the owner.

Everyone else is considered to be non-eligible designated beneficiaries (non-EDBs), including non-minor children of the IRA owner or any other primary beneficiary, minor grandchildren, EDBs who lose their EDB status, and any successor beneficiary, including someone who would otherwise be an EDB or a successor of a pre-2020 beneficiary.

“These non-EDBs are now subject to the 10-year rule. What the 10-year rule says is non-EDBs must withdraw the entire balance in the IRA within 10 years of the death of the owner,” he said. “And more specifically what they mean by that is Dec. 31 of the year that holds the 10th anniversary of the owners death.”

This applies to any account where the owner died after 2019, when the SECURE Act was passed. So if the owner died in 2019 or prior, the old rules apply, but if the owner died in 2020 or later, the new rules apply.

“Now this is where it gets interesting, because under what we thought was happening with the SECURE Act, the 10-year rule was pretty straightforward—you have to empty the account within 10 years. You can do whatever you want in years one to nine, but by the end of that 10th year you have to empty that account,” Steffen said. “About two months ago, the IRS came out with their proposed regulations, which is their interpretation of the tax code that Congress wrote. So here’s what we have now: If you have an IRA owner who died after 2019 and who left the IRA to a non-EDB, you have two different treatments.”

If the owner died before their RBD, that beneficiary is subject to the 10-year rule, where they can do whatever they want in terms of distributions in years one through nine, but they have to empty the account in year 10.

But if the owner died after their RBD, meaning they were taking distributions, the beneficiary has the 10-year rule but also has to take distributions in years one through nine, like they would have under the old stretch IRA rules, he said.

“Here’s the crazy part about this—the IRS says the presumption is this rule has always been in place. So in cases where the owner died in 2020, the beneficiary had to take a distribution in 2021 that they didn’t know about until March 2022,” Steffen explained. “So there’s this uncertainty. What happens for these owners who died in 2020 where the beneficiary had to take something out in 2021 under these rules? We don’t know the answer to that yet.”

Steffen said he expects more clarification later this summer. “If clients fall into this category, they may have had to take a distribution for last year and they might have to take one for this year, so stay tuned,” he said. “Prepare your clients. If they’ve got inherited accounts they may have to take a distribution this year, maybe even two to make up for last year’s if they missed it.”

 

According to Steffen, unique situations include:

Helping Recipients Manage The Tax Burden
There are some serious considerations when tax planning for recipients, he said.

“Instead of taking smaller RMDs for years one to nine and then a big amount at the end as the account is emptied, it may be more advantageous for clients to take more level payments through years one to nine and avoid the big pop at the end,” he said. “That’s just the distributions—the real impact is the tax cost.”

Steffen used the following scenario as an example: an owner dies with $1 million IRA, left to a 55-year-old child, where the pre-tax return is 7% and the after-tax return is 5.5%, and the beneficiary is in the 40% tax bracket.

“Under the old tax rules, the beneficiary could take only those RMDs annually, pay the tax and then let the balance sit in a taxable account and not touch it so that it grows each year. The majority of the bequest would continue tax-deferred,” he said. “Under the new rules, the beneficiary has to liquidate that account within 10 years, and everything is now taxable. Over a 30-year period you can see the lost value to that beneficiary is approaching $600,000. Why is that? They’ve got a lot few years of money growing tax-deferred under a traditional IRA, and they’re taking out larger pieces of it and the tax hit’s much bigger. So that’s why there’s all this lost value.”

Another wrinkle, he continued, is that if the beneficiary is in a lower tax bracket without these distributions, the distributions themselves might push the beneficiary into a higher tax bracket, and the lost value is even greater. Using the same example as before but with a beneficiary otherwise in a 30% tax bracket, the distributions would push that beneficiary into a 38% tax bracket.

“And the lost value is now $1.115 million over 30 years, simply because they don’t get the tax-deferred growth anymore and they’re paying a lot more in taxes over a period of time,” Steffen said. “You’re going to have clients who are going to look at that and say that’s not their intention, and what can be done about it? 'How do we make sure my kids don’t lose out on that million dollars in value?'”

Steffen identified seven planning strategies around the 10-year rule, where the impact is felt by the beneficiary, not the owner, but only the owner can change the outcome. Each option requires deeper examination within a client’s individual situation:

“The only one who can really do something about this is the owner themselves, because once the owner dies and passes the IRA to the beneficiary, the beneficiary is locked in,” he concluded.