New SECURE Act 10-Year Distribution Rule for Inherited IRAs and 401(k)s May Affect Your Estate Plan
If you own an IRA or 401(k) that will be inherited on your death, the rules that apply to inheritance of those assets just changed significantly. The change accelerates required distributions for many beneficiaries. The new rule is part of the federal SECURE (Setting Every Community Up for Retirement Enhancement) Act, enacted at the end of 2019.
This change in the law substantially impacts estate planning for those assets. It especially affects estate plans of individuals who want their children and grandchildren to benefit from an IRA or 401(k) plan.
Mandatory 10-Year Full Distribution for Inherited IRAs and 401(k)s
Previously, a beneficiary inheriting an IRA or 401(k) could allocate withdrawals over their estimated lifetime. Under the SECURE Act rule, a beneficiary now must withdrawal all assets from the account within 10 years of the account owner’s death. The new rule significantly shortens the distribution period for many beneficiaries, including those who inherit at a young age.
The revision applies to all IRA and 401(k) accounts inherited on or after January 1, 2020. Accounts inherited before that date are not affected and are still subject to the previous lifetime distribution rule.
There are exceptions to the 10-year rule. Importantly, it does not apply to a surviving spouse. If a spouse inherits assets an IRA or 401(k), the spouse may still allocate withdrawals over his or her estimated lifetime. But if assets remain in the account when the surviving spouse passes away, the 10-year rule then applies to the account. The rule also applies to all non-spouse beneficiaries, unless the beneficiary falls under one of four other narrow exceptions.
Under the 10-year rule, a beneficiary may spread distributions over the full 10 years, or take the entire sum at the end of the period.
Negative Effects of the 10-Year Distribution Requirement
Especially for an IRA or 401(k) with substantial assets, the shorter distribution period has significant negative implications and can undermine the estate planning goals of the account owner. The previous rule enabled account assets to grow tax-free for an extended period of time in many cases. It also had the advantage of minimizing income tax implications for the beneficiary, because distributions could be spread over a longer period.
Since withdrawals are taxed to the beneficiary as personal income, accelerated withdrawals under the 10-year rule means that the higher distributions could increase the beneficiary’s marginal tax rate. If that occurs, more tax is paid on the asset distribution, as well as on the beneficiary’s other income. So, the federal government gets more of your money — and more of the beneficiary’s other income as well.
The 10-year distribution period also results in many beneficiaries controlling more assets within a shorter amount of time. Especially for younger beneficiaries, that situation is not usually desirable. It can result in assets being wasted or squandered or make assets vulnerable to creditors and other claims, including those of a divorcing spouse in some circumstances.
Beneficiaries Exempted From the 10-Year Rule
The SECURE Act establishes five categories of “eligible designated beneficiaries” (EDBs) who are exempt from the 10-year distribution requirement. EDBs may still take inherited IRA and 401(k) distributions over their estimated lifetime. The five categories include:
- Surviving spouse
- “Disabled” beneficiary
- “Chronically ill” beneficiary
- Minor child of the account owner (exempted only until age 18 in Arizona)
- Beneficiary not more than 10 years younger than the account owner
For both “disabled” and “chronically ill” beneficiaries, the law includes specific criteria that must be met to be eligible for the exemption. Both sets of criteria are extremely restrictive.
A minor child of the account owner who inherits an account becomes subject to the 10-year rule on reaching the age of majority, which is age 18 in Arizona. As a result, the child would be required to withdraw the full assets by age 28. Few parents want their children to have complete control over an inheritance by that age.
The exemption for a minor applies only to the child of the account owner. It does not apply to other minor beneficiaries, like grandchildren. As such, it is possible that a minor beneficiary who is not a child of the account owner would receive the full distribution at an age younger than 28.
If an EDB inherits an IRA or 401(k), and assets are left in the account on the EDB’s death, the account will become subject to the 10-year rule, unless the subsequent beneficiary of the account qualifies as an EDB under one of the exemptions.
Effect of the SECURE Act 10-Year Rule on Your Estate Plan
The new rule creates risks for inherited IRAs and 401(k)s that did not exist under previous law. It also undercuts the goals of many existing estate plans.
If you own an IRA or 401(k), your estate plan must take the new distribution rule into account. Fortunately, strategies and options are available to address the negative impacts of the new rule. The best approach in a specific case depends entirely on an individual’s personal and financial situation, estate planning goals, and current estate plan. If you own an IRA or 401(k), it is essential to review your estate plan with an experienced estate planning attorney in the near future.
In addition, if you own an IRA or 401(k) and are relying on beneficiary designations rather than an estate plan, you should talk with an attorney about creating a plan. Passing along those assets after your death just became much more complicated than it was previously. Creating an estate plan is the only way to protect your assets and beneficiaries and implement your wishes for your family’s future.
Other Changes for IRAs and 401(k)s in the SECURE Act
The new law has two other provisions that impact IRAs and 401(k)s as of January 1, 2020. These changes will benefit some account owners.
First, the SECURE Act increased the age for initiating required minimum distributions (RMDs) from age 70½ to age 72. This change applies to individuals who reach age 70½ in 2020 and subsequent years. It does not apply to anyone who turned 70½ in 2019 or earlier.
In addition, the Act removed the prohibition on account distributions after age 70½. An individual who continues to work and earn income can still make contributions at any age. This revision applies to the tax year 2020 and after. It does not apply for the 2019 tax year.
Schedule a Free Consultation With an Experienced East Valley Estate Planning Attorney to Discuss the Impact of the SECURE Act on Your IRA or 401(k) Plan
If you own an IRA or 401(k) plan, you should talk with a knowledgeable estate planning attorney about how the SECURE Act provisions impact inheritance of those assets. At Peterson Law Offices, wills, trusts, and estate planning are a focus of our practice. We stand ready to assist clients who own retirement accounts affected by the SECURE Act.
Attorney Shane Peterson takes great pride in providing high-quality services at affordable prices to clients throughout the East Valley, including Queen Creek, San Tan Valley, Gilbert, Mesa, and Chandler. You may schedule your free initial consultation by calling 480-878-5998 or using our online contact form.