The tax rules for inherited IRAs have always been complicated. But the SECURE Act, and the recently related IRS regulations, have made beneficiary IRAs the worst possible assets for wealth transfer and estate planning.
Not only is the stretch IRA gone for most beneficiaries, but beneficiaries and advisors alike will be hard-pressed to navigate the minefield of convoluted new RMD (require minimum distribution) rules.
As I wrote about in an earlier InvestmentNews column, the best overall advice to beneficiaries is to ignore the RMD rules.
Because of the SECURE Act, there are now three different categories of beneficiary. And, worse, the rules within each category are different depending on what year the original IRA owner died and whether that person died before or after his RBD (required beginning date) for starting RMDs. (The RBD is generally April 1 of the year following the year someone turns age 73.)
Most beneficiaries will be NEDBs subject to the 10-year rule, meaning their entire inherited IRA must be withdrawn by the end of the tenth year following the year of death. But some of these beneficiaries will also be subject to RMDs for years one to nine of the 10-year term if they inherited from a person who had already reached their RBD.
Other beneficiaries who qualify as EDBs can still do the stretch IRA. There are five classes of EDBs:
1. Surviving spouses
2. Minor children of the account owner, until age 21 – but not grandchildren
3. Disabled individuals – under strict IRS rules
4. Chronically ill individuals
5. Individuals older than, or not more than 10 years younger than, the IRA owner.
These EDBs all qualify for the stretch IRA, but they are not all alike. For example, those who inherited from someone who died before their RBD can also elect the 10-year rule. And EDBs who are minors only qualify for the stretch temporarily, until age 21. Then they fall into the 10-year rule and have to continue annual RMDs for years one to nine of the 10-year term.
Finally, there are NDBs, like an estate, charity or non-qualifying trust, that have their own set of RMD rules, again depending on whether the IRA owner died before or after the RBD.
The RMD rules for special needs trusts for disabled or chronically ill beneficiaries were liberalized by the SECURE Act. Even so, IRAs are still poor assets to leave to these trusts. Yes, the stretch IRA and the trust protection may be available, but at what cost? If special needs beneficiaries receive too much of an RMD payout through the trust, they could lose government benefits like SSI payments. But if the trust retains the funds to protect them for beneficiaries, high trust taxes could apply, leaving these beneficiaries with less.
Even after a beneficiary dies, the RMD perplexity continues for those who inherit from the beneficiary – the beneficiary’s beneficiary. These beneficiaries are known as “successor beneficiaries,” and they, too, are subject to an array of baffling RMD rules depending on what year they inherited, what category of beneficiary they inherited from, and under what payout schedule the original beneficiary was taking RMDs.
In addition to these beneficiary RMD calculation complications, RMDs could push beneficiaries into higher tax brackets, especially those who wait to withdraw the full inherited IRA balance until year 10 of the 10-year term. In addition to higher taxes, the additional 3.8 percent tax on net investment income could apply. While RMDs themselves are not subject to this tax, they do increase taxable income, which could subject investment income to the 3.8 percent levy.
Inheriting an IRA thus creates a domino effect of increased taxes and various RMD enigmas.
This part is easy, and yields better tax results for IRA heirs: Get rid of RMDs for beneficiaries. Let tax planning drive distribution planning, not RMDs.
First, stop adding to the problem. Cease funding pre-tax IRA and 401(k) contributions.
Second, start trimming IRA balances before they are inherited in order to minimize taxes and the beneficiary RMD confusion.
The best way to reduce IRA balances is with a series of Roth conversions over the next several years, taking advantage of current low tax brackets. Also, start contributing to Roth 401(k)s and Roth IRAs instead of pre-tax 401(k)s and IRAs.
Roth IRAs are the best gifts for beneficiaries. Even though inherited Roth IRAs are subject to the same payout rules that apply to pre-tax IRAs, the RMDs usually come out income tax-free.
Inherited Roth IRAs are also never subject to RMDs for years one to nine of the 10-year term, so those funds can continue to accumulate tax-free for the full 10 years.
Roth IRAs are also better to leave to a trust since high trust taxes can be avoided, while maintaining trust protection for beneficiaries.
Another option for reducing IRA balances is to withdraw those funds at low tax rates and pour them into permanent (cash value) life insurance. Don’t do this before age 59-and-a-half, however, because a 10 percent penalty for early distributions could apply. (By contrast, Roth conversions can be done at any age, since the penalty doesn’t apply if all withdrawn funds are converted and not withheld for taxes.)
With both life insurance and Roth IRAs, beneficiaries won’t have to worry about taxes and can keep more of their IRA inheritance. Plus, they can avoid complex RMD scenarios.
Traditional IRAs are terrible assets to inherit. It’s time to rethink tax planning by having clients reduce IRA balances so their beneficiaries can be spared these unsolvable RMD puzzles.
For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com
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