At the end of 2019, Congress passed the SECURE Act, which introduced sweeping changes relating to Individual Retirement Accounts (IRAs). These changes affect the planning around and opportunities available through IRAs.
One notable change is the elimination of “stretch” provisions for most non-spouse beneficiaries of inherited IRAs and other retirement accounts. Your spouse can still inherit your IRA and roll it over into their own existing IRA or leave it as an inherited IRA. However, if the primary beneficiary of your account is your adult children or grandchildren, they will have to withdraw all the account’s funds within 10 years.
Prior to this law change, non-spouse beneficiaries could take distributions from the inherited IRA over their life expectancy, hence the term “stretch.” Now they will have to empty these IRAs, and pay the corresponding income tax, over just 10 years.
Typically, all distributions from a traditional IRA or 401(k) account are taxed as ordinary income. You received a tax deduction when contributions were made, and the income and growth on the assets are not taxed until a distribution occurs. Either you or your account beneficiaries will pay the tax when funds are distributed.
Now, this tax will be paid in a much shorter timeframe (the 10-year rule applies to inherited 401(k) accounts, too), and that could push you into a higher tax bracket. If you inherit a parent’s IRA at age 40, you will need to empty the IRA by the time you are 50. You do still have flexibility to determine when over those 10 years you take the distributions. You could withdraw all the funds immediately, take them ratably over the 10 years, or wait until the 10th year to take the entire amount.
Let’s look at the difference between if Gerry, the owner of a $500,000 IRA, died prior to 2020 or after Dec. 31, 2019. In either case, he leaves his IRA to his son, Dave. (This is a hypothetical example, for illustrative purposes.)
If Gerry died in 2019, Dave is 40, and per the life expectancy tables, can stretch his distributions over 42.7 years. To determine how much he must take each year, divide the account balance on Dec. 31 of each year by his life expectancy. At Dec. 31, 2020, Dave divides the $500,000 balance by 42.7 to calculate his $11,710 required minimum distribution.
In each subsequent year, the life expectancy factor is reduced by one (1). By the time Dave is 45, the year-end balance will be divided by 37.7. If Dave were to die young, leaving his inherited IRA to his daughter, she would continue to take annual distributions using the same life expectancy schedule that Dave was.
If Gerry were to die in 2020, Dave has only 10 years to take the entire inherited IRA balance. The distributions will need to be thoughtfully planned based on his expected income tax bracket now and over the next 10 years.
Making full use of Roth 401(k)s and Roth IRAs and converting your traditional IRA to a Roth IRA may be even more attractive. Contributions to Roth accounts come after-tax, but distributions are tax-free. The longer assets are in Roth accounts, the greater the prospects for tax-free growth. If you plan on leaving your IRAs and other retirement accounts to future generations, taking advantage of the Roth option could be the way to go.
Connie Brezik is a Casper-based wealth adviser with Buckingham Strategic Wealth. Her email is email@example.com
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