For many years, individuals inheriting IRAs could benefit from IRS rules allowing for long-term tax deferral. The owner of the inherited IRA could withdraw whatever amount they wanted whenever they wanted without penalty, regardless of their age. They needed only to take required minimum distributions (RMDs), which they could “stretch” out over their life expectancies, according to the IRS table. For example, a 40-, 50-, or 60-year-old inheriting an IRA would need to withdraw 2.3 percent, 2.9 percent or 4.0 percent respectively in the first year of withdrawal. As such, the IRAs were often referred to as “stretch IRAs,” as the original owner could enjoy tax deferral for decades and the inherited IRA owner could benefit from tax deferral for decades more.
For inherited IRA owners where the original owner died in 2019 or prior, there is no change. They can continue taking the relatively low RMDs over their life expectancies. But the SECURE Act of 2019 significantly changed the rules for an inherited IRA when the original owner dies in 2020 or later.
The new regulation dictates that the inherited IRA funds must be completely withdrawn by December 31 of the 10th year after the death of the original owner. The rule applies to both traditional and Roth IRAs. For example, if you inherit an IRA in 2021, you have until December 31, 2031 to withdraw the full balance, paying the applicable income tax in the years you make the withdrawals.
There are some exceptions, such as IRAs left to a spouse or a minor, IRAs inherited where the age difference between the beneficiary and the original owner is less than ten years, and for the disabled or chronically ill. There is also deferred implementation for funds inherited from a 403(B) or 457 plan.
The impact can be particularly significant on the young and working—that is, those who are still earning. They and their spouse could already be in a relatively high tax bracket. Adding on taxable income from a withdrawal from an inherited IRA , not only accelerates when income tax is paid (the 10-year rule), but in many cases, it is taxed at a much higher rate than what might have been under the old rules.
Planning to lessen the impact
There are planning options to lessen the impact of the new IRS rule. For one, there are no RMDs associated with an inherited IRA. The new owner can spread the income relatively evenly over 10 years. Or wait to the tenth year to take it all. Or take it over a period when they expect to be in a lower tax bracket. For example, a 60-year-old planning to retire in five years might spread the income over the first five years of retirement when their income is lower but before their own RMDs begin at age 72.
Planning involves several considerations. Will income tax rates be higher than today? When will you retire and what will your taxable income be in the early years of your retirement? And how will you be impacted by the Medicare Income-Related Monthly Adjustment Amount (IRMAA) that could significantly increase your Medicare Part B premium as well as your Part D prescription drug plan costs.
Some parents concerned about the negative impact these new regulations will have on their children have added a life insurance policy to their estate plan to, in effect, cover the higher tax burden.
The key is to plan, plan, plan. There are estate planning opportunities for parents leaving IRA funds to their children and grandchildren. There are also income tax planning opportunities for the inherited IRA owner, which should take place as soon as possible after inheriting an IRA.
We can help. Your HBKS financial advisor, collaborating with our partners at HBK CPAs & Consultants, will develop a plan to address your particular situation. Call us at 800-823-0617; or email me for more information at firstname.lastname@example.org.
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