New, Tighter Distribution Rules
Art by Katie Hicks
When tax-deferred individual retirement accounts were introduced in 1974, they were designed for workers not covered by a qualified retirement plan. Later, they became available to all U.S. working taxpayers, and, as money in traditional IRAs is tax-deferred, they have become a common tax- and estate-planning tool.
When the fund-owner reaches 72—or when the beneficiary, if the owner has died, receives the bequeathed IRA—that person must begin taking required minimum distributions.
Earlier this year, the IRS published proposed regulations that, by virtually eliminating the so-called “stretch” IRA provision, will reduce the time frame over which most heirs must complete the withdrawal. The regulations were called for by the Setting Every Community Up for Retirement Enhancement—aka SECURE—Act of 2019. Effectively, the regulations require that inherited IRA funds must be drawn down as income in no more than 10 years; this means a larger amount of money must come out of the IRA over a shorter period of time and be taxed.
The regulations will affect inherited 401(k) accounts, as well as IRAs. Thus, it is important for plan advisers to be mindful of what the changes mean for retirement savers and plan sponsors.
Get Educated
Under current rules, some beneficiaries have been able to draw down the money over decades, for example if the IRA owner named a child or a grandchild as the beneficiary. Because of children’s long life expectancy, the beneficiary could spread out the required distributions, and thereby the tax deferral on the account’s principal, over many years. For the youngest inheritors, this could mean 50, 60, 70 or even 80 years of tax deferral, according to Ed Slott, certified public accountant and professor of practice at the American College of Financial Services.
“I think the IRS rules are the final nail in the coffin for IRAs as an estate-planning vehicle,” Slott says.
The new rules are complex, hence the large number of retirement savers now concerned that they need to make a change in their planning, Slott says. Financial advisers should educate themselves on what is changing and why, engage with their clients and offer up alternatives such as Roth IRAs or life insurance, he says.
Slott suggests identifying those clients with the largest IRAs—where the account’s balance will probably not be consumed in the client’s own lifetime. These accounts are the ones most likely to be left over to the next generation and to fall under the new rules about RMDs. Owners of these IRAs will be interested in knowing whether their plan to bequeath their account will still hold up, he says.
“The last thing an adviser wants to hear when a client has died is the beneficiaries asking, ‘How come you didn’t update this plan? You didn’t know the rules changed? Now we’ll have to take all this money out in 10 years, and the taxes will cost us a fortune,’” Slott says.
Ronald Cluett, of counsel at Caplin & Drysdale, recommends that advisers discuss with each plan sponsor client how its plan treats RMDs. “What happens when someone dies? What happens when someone hits normal retirement age after leaving the company? Start there,” he says.
This is important to review, Cluett says, even if the majority of a plan’s participants will roll their money over to an IRA before they are forced to take RMDs, or before their account must be passed to a beneficiary.
Exemptions
When the SECURE Act eliminated the stretch IRA, it did allow for multiple categories of exemptions to the 10-year window, the most notable being the surviving spouse. Others include a disabled person, a minor child (but not a grandchild) of the deceased IRA owner and someone no more than 10 years younger than the IRA owner. Congress named these special beneficiaries “eligible designated beneficiaries.”
According to Slott, there is another “unwritten” category of such EDBs. The SECURE Act is effective only for inheritances received in 2020 or later, he explains. If a beneficiary, such as a grandchild, inherited in 2019 or earlier, that person would be grandfathered under the old rules and thus be able to stretch the time. But when that beneficiary dies, the new beneficiary will not have the option to stretch what remains, he says.
Part of the confusion in the market comes from an old rule referred to as the “at least as rapidly” rule, Slott notes. Under this rule, once the IRA holder begins disbursements, the beneficiary must use the same process for disbursement, Slott says. “In other words, RMDs, once they’re turned on by the IRA owner during that person’s life, can’t be turned off by the beneficiary,” he says.
The confusion stems from the IRS essentially saying that both the “at least as rapidly” rule and the 10-year rule may apply to the same beneficiary if death was after the required beginning date of the distributions.
“So, they sort of have the old stretch IRA for nine years, and then a balloon payment at the end of year 10. Then everything has to come out. This was the fly in the ointment that changed all the planning and is causing confusion,” Slott says.
Despite the confusion and complexity, RMDs are not to be taken lightly, Cluett says. “Mistakes with RMDs can create a host of tax and legal issues for the plan and/or the participant who received an incorrect RMD, or didn’t receive one when she should have received one.”