Don’t leave your beneficiaries with a large tax burden due to the new 10-Year Rule. Look into cashing gains out in retirement, and gifting cash to them.

Losing a loved one is an extremely emotional time, executors have a tough responsibility to wrap up the deceased(s) finances, file their final tax returns, and close out the estate. Unfortunately, with all of the stress, the tax implications are often overlooked until it’s too late.

Estate planning for 401(k)’s and IRAs completely changed after 2019, this article will help explain the tax implications of the changes to those of you leaving or inheriting a 401(k)/IRA. Those of you who’ve been involved in the estate of a loved one know how startling the tax implications can be. Many beneficiaries are startled to find out they will owe taxes on their parent(s) or grandparent(s) life savings.

All of the distributions from an inherited (IRA/401(k)) are taxed to the beneficiary as ordinary income.

This ordinary income hits many beneficiaries (children/grandchildren) in their prime earning years pushing them up multiple tax brackets, taxing any additional income earned (from work/investing) at a higher rate.

Let’s take a look at how IRA/401(k) inheritance(s) worked before and after the passing of the SECURE Act of 2019.

Prior to the Secure Act of 2019, there were two types of beneficiaries per tax law.

1. A Designated Beneficiary was a person for whom a life expectancy could be calculated
   • not estates, charities, corporations or most trusts
2. A Beneficiary was typically estates, charities and most trusts.

If the goal is to defer taxes, it was and still is even after the SECURE Act, critically important one or more individuals, and only individuals are named as beneficiaries of an IRA because a Designated Beneficiary got preferred tax treatment over a Beneficiary.

The tax implications and withdrawal timelines for a designated beneficiary depended (and still depends) upon whether they are a spouse or non-spouse.

The rate at which funds need to be taken from the Decedent’s retirement account depend on whether or not the decedent died after Required Minimum Distribution (RMD) payments began. If the decedent died after the RMD payments began (the Required Beginning Date (RBD)), the beneficiary must take RMD payments “At Least As Rapidly” as the method being used. Contrary to what one may think, it does not mean a beneficiary is stuck with the parent’s or spouse’s (IRA owner’s) RMD, and that they cannot stretch out the IRA distributions across multiple years.

In fact, the “At Least As Rapidly” rule does not apply at all to spouse designated beneficiaries. It simply means a non-spouse beneficiary (or elected spouse beneficiary) could not lengthen the distribution schedule of the original owner’s retirement account, over a longer period of time than was originally elected by them at their RBD.  The “At Least As Rapidly Rule” was and is confusing for many, including professionals, and costs many beneficiaries a fortune in lost tax deferral because they assume it means the assets need to be distributed faster, losing precious tax deferred asset growth over decades using what was called a “Stretch IRA”.

The SECURE Act of 2019, for spouses didn’t change the Stretch IRA.

As a spouse, if you are named as a beneficiary, you have three options:

1. Treat the account as your own (only for those named sole beneficiary, with 100% withdrawal rights)
2. Rollover (We recommend trustee-to-trustee transfer) the funds to an IRA or another qualified plan in your name (for sole/non-sole beneficiary spouses)
3. Treat yourself as a beneficiary of the account (Electing to not treat the IRA as your own, and subjecting yourself to “At Least As Rapidly” rules).

Each of these options has pros and cons depending on the spouse’s financial situation:

1) Treat the account as your own

• This re-designation allows the spouse to make deductible contributions to the IRA plan and subject them to a 10% penalty on early withdrawals. The spouse is only subject to RMD requirements upon reaching the age of 70 ½ (72 after The SECURE Act), with the exception the spouse must take any RMD that would have been required of the deceased for that year.
• This option is typically the most tax effective option, as it creates the longest tax-deferment period of the funds. The disadvantages are that this option is not available to spouses who are not sole designated beneficiaries. Additionally, it is not ideal for those who need access to the funds in the near future because of the early withdrawal penalty.

2) Rollover to an IRA or another qualified plan in your name

• The rollover of the assets needs to occur within 60 days of the distribution. This option provides tax deferral to spouses even if they are not sole designated beneficiaries. It is also more administratively convenient for spouses who already have one or more IRA accounts. Similar to the first option, a spouse under age 59 ½ is generally unable to access the funds without paying a 10% penalty.
• Typically, my firm (www.Corridor-Consulting.com) prefers to see a trustee-to-trustee transfer, which electronically moves funds from the decedent’s IRA or retirement account directly to the surviving spouse’s IRA avoiding a potential mix up and withholding tax problem caused by investment firms cutting a check and misclassifying the distributions.  This is still the case after the SECURE Act passing.
  • If funds are incorrectly distributed there is no method to return those dollars to an inherited IRA. They must remain distributed, and taxes will be due all at once.

3) Treat yourself as a beneficiary of the account

• The benefit of this election is for spouses under age 59 ½ who want to access IRA funds in the foreseeable future. They are subject to beneficiary RMD tables, which are more aggressive than the RMD tables for IRA owners. However, that 10% penalty does not apply, and distributions to a sole designated beneficiary spouse (if they elect) did not have to begin until December 31st of the year the decedent would have reached 70 ½ (72 after The SECURE Act).

As a non-spouse prior to the SECURE Act of 2019, if you were named as a beneficiary, you had two options depending on if RMDs already began.

• The Life Expectancy Rule
  • The designated beneficiary had to take RMD payments based on the longer of the decedent’s life expectancy or the beneficiary’s life expectancy.
• The Five-Year Rule
  • The beneficiary had to withdraw the entire interest from the IRA by December 31st of the year containing the fifth anniversary of the decedent’s death. The beneficiary was free to withdrawal any amount before the five-year date, or to wait until the fifth year to withdraw the entire interest.

If the decedent died after RMD payments began the beneficiary could elect The Life Expectancy Rule OR The Five-Year Rule. If the decedent died after RMD payments began The Life Expectancy Rule was in place. The most tax efficient method for beneficiaries who were young, and didn’t need the funds immediately was The Life Expectancy Rule.

This meant an 18-year-old who suddenly had their parent pass away at 60, could effectively take distributions across their life expectancy based on IRS tables for up to ~64 years after the death. This allowed the inheritance to grow tax-deferred for a very long time through what was commonly referred to as “The Stretch IRA”

The SECURE Act of 2019, for non-spouses killed the Stretch IRA.

The SECURE Act of 2019- The Replacement of the Life Expectancy Rule, to the 10-Year Rule for (almost all) Non-Spouse Beneficiaries.

The SECURE Act of 2019 grandfathered in those who inherited 410(k)/IRAs before 2020 to the previous rules above. It didn’t change the rules for spouses, or the five-year rule for accounts who didn’t have a designated beneficiary. It did however introduce new unfavorable rule for non-spouse beneficiaries called the 10-year Rule.

Under the 10-Year Rule, the beneficiary has to withdraw the entire interest from the 401(k) and/or IRA by December 31st of the year containing the tenth anniversary of the decedent’s death. The beneficiary is free to withdrawal any amount before the ten-year date, or to wait until the tenth year to withdraw the entire interest.

If you miss the distribution window within the 10-Year Rule. The IRS imposes a 50% excise tax penalty on the amount remaining in the account.

There are exemptions to the 10-Year Rule if a non-spouse beneficiary can qualify as an Eligible Designated Beneficiary (EDB).

An EDB is the following:

1. A surviving spouse
2. A minor child of the deceased IRA owner
   • A minor child is any child under the age of majority in his/her state (18 in most)
   • Grandchildren do not count as minor children.
3. A disabled or chronically ill beneficiary
4. A beneficiary who is not more than 10 years younger than the deceased IRA owner.

When a minor child reaches the age of majority (18 in most states) the 10-year rule relating to withdrawal requirements kick in.

An EDB minor child shall cease to be an eligible designated beneficiary as of the date the individual reaches majority and the balances in the 401(k) and IRA(s) must be distributed within 10 years after such date ((H.R.1994)- Congress).

Because of this change, The SECURE Act of 2019 has accelerated distributions that would have occurred over decades, 65+ years in the case of 18-year old’s who were Designated Beneficiaries under the old law, to just 10 years!

How does The SECURE ACT of 2019 financially impact your non-spouse beneficiaries for the worse? Real world examples.

Let’s say your 30-year-old son or daughter makes $80,000 a year from wages, and takes the standard deduction of $12,950 (files single) in 2022, they’ll have $67,050 in taxable income and be in the 22% federal tax bracket.

Meaning they can earn an additional $22,025 in ordinary income, and have it taxed at 22%, if they make 22,026, that next dollar is taxed at 24%. See how a large one-time inheritance could be very detrimental?

Not only will they move up in the marginal income tax brackets, they could also move up in the Capital Gains brackets, subjecting them to a 20% tax on investments vs 15%.

More so, if they receive bad advice from a professional that tells them they need to deplete the account “At Least As Rapidly”, they could make the very unwise decision to just take the entire distribution out pushing them into the 37% bracket, and if they live in a state with high state income taxes, it could add upwards of 10% more in taxes due.

Let’s say you leave your adult son or daughter $1,000,000 in your 401(k) or IRA.

Under the SECURE Act if they don’t qualify as an EDB, they need to take those funds under the 10-year Rule. They don’t have to take distributions every year, but by December 31st of the year containing the tenth anniversary of your death they need to fully deplete the account, or be subject to a 50% excise tax on the entire balance remaining. They can take it all in a single year, but it would subject them to taxes at the highest brackets. If they take it all in 2022, they’d have a $357,764 tax bill, putting them at an effective tax rate of 34%

The only tax efficient option they have is to take it over 10 years.

And that’s still an additional $100k of income each year! Based on the example above, they’ll now have a taxable income of $167,050 ($67,050 +$100,000). Based on the 2022 brackets, $22,025 will be taxed at 22%, (~$4800), and 77,975 at 24% ($18,700).

So, each year 23.5% of the distribution will go to taxes.

Additionally, they can only earn an additional $3,000 per year before all of their additional income will be taxed in the 32% tax bracket.

Prior to the Secure Act of 2019 they would have been allowed to take RMD payments based on the longer of your life expectancy or their life expectancy. According to IRS tax tables in 2020 (see above), for a 30-year-old that would have been an additional 53.3 years!

That means under the old rules your funds could have grown tax deferred for 53 years vs 10 years.

The old rules also lowered the tax bill each year for you beneficiary, as they are only required to take ~$19,000 a year, which would be added as taxable income putting the $167,050 figure above, to only $86,050 at an estimated bracket of 22% for a tax on the distributions each year of $4,180.

So, in our example, how bad does this hurt your beneficiary? Let’s put an estimate on it.

Below is a chart of the tax cost to the beneficiary after 10 years, and after 53 years. You can see the savings is only $13,460, but this is extremely simplified and incorrect.

On both sides of the spreadsheet, we are assuming the funds are still not invested.

Perhaps that is a good choice on the right side, if the beneficiary wishes to not have any market risk over 10 years. On the left side? Over 53 years for a 30-year-old already earning an income? That doesn’t seem like a good choice.

Let’s assume the money makes a measly 4% every year for 53 years. We get something like this:

Your 30-year-old child prior to The SECURE Act of 2019- could have taken an annual distribution of $43,961 every year, for 53 years, totaling $2,329,880 in distributions and fully depleting the account at age 83.

How does that change our end tax result? Let’s assume the recipient has been maxing their own ROTH IRA/401(k) and plans to retire at 62 because they now have no other taxable income other than the taxable IRA you left, they are in a much lower tax bracket.

Let’s take our total distributions of $2,329,880 and divide by the total tax paid, that’s 16% compared to our 23.5% effective tax on distributions above under the new 10-Year Rule, or a 7.5% effective tax reduction.

So prior to the 10-Year Rule, your 30 year old child investing your IRA funds at a 4% annual return would have seen a 233% return on your assets, and had access to a lifetime payment.

This is why The SECURE Act of 2019 has changed for the worse. It’s sad to see this go away, when many clients want to ensure their beneficiaries are taken care of for the rest of their lives. Now it’s not possible to leave funds you contributed, and have them grow tax deferred over the life of your children or grandchildren.

So, what options do you have to decrease the 23.5%-34% effective tax burden based on your beneficiaries income?

In the case you know your beneficiaries may have to take your funds over 10 years you may want to think about taking more distributions in retirement and paying taxes (to maximize your lower income tax brackets) and gift the maximum of $16,000 (2022 gift exclusion) or $32,000 (marital gift splitting) each year to each beneficiary tax free. Other options include ROTH conversions as well.

These are solid strategies if you are near the life span of your past relatives, or are currently planning your estate upon finding out you have a terminal disease. As the years of tax-free growth are limited for you, and will be limited now for your beneficiaries to 10 years due to these changes.

If you need any help regarding these issues, please reach out to Corridor Consulting, we would love to assist you in any issues you may have. If you’d like to schedule a consultation you can do so here.

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This article is not professional tax or legal advice for your specific circumstances. Consult with your professional adviser to better understand how these items may impact you, or how they’ve changed