Michael Zaidlin, J.D., Madrone Investment Advisory
The SECURE Act of 2019 eliminated the highly favorable lifetime “stretch” for many beneficiaries of retirement accounts who inherited those accounts after January 1, 2020, with many retirement account beneficiaries now required to fully distribute the account by December 31 of the tenth year following the year of the account owner’s death — the “10-year rule”.
SECURE 2019 was further expanded upon by the signing into law of SECURE 2.0 in December of 2022, which added nearly one hundred more provisions impacting retirement accounts, with each provision having its own implementation date ranging from 2023 to 2028. Additionally, the IRS notice of proposed regulations, issued in February of 2022, has added even more complexity to the beneficiary distribution rules.
Five classes of beneficiaries — the surviving spouse, the decedent’s child prior to reaching age 21, the disabled, the chronically ill and beneficiaries who are not more than ten years younger — are still permitted to base required annual distributions on their life expectancy. Collectively, these five classes constitute “Eligible Designated Beneficiaries”, or EDBs, in contrast to those who do not fall into one of those five categories”. These “Non-Eligible Designated Beneficiaries” are required to use the 10-year distribution rule.
While largely unfavorable to retirement account beneficiaries, the SECURE Acts contain many changes favorable to retirement account owners. In particular, SECURE 2.0 raises the age at which IRA account owners must start taking required minimum distributions to 73 for anyone born in or after 1950 and before 1959, and to age 75 for those born in 1959 or later.
Further, beginning in 2024, a surviving spouse can elect to be treated as the original IRA owner, an option that could allow an older surviving spouse to take smaller RMDs than otherwise. SECURE 2.0 also contained good news for 529 education savings account beneficiaries who, assuming a number of conditions can be met, will be able to roll a maximum of $35k from their 529 account into that beneficiary’s Roth IRA account beginning in 2024. Among other conditions, the 529 account has to have been open for a minimum of 15 years, and the rollover must be done over a period of years.
However, the issuance of the IRS’s proposed SECURE Act regulations in February of 2022 surprised nearly everyone, as it had been widely assumed that the ten-year rule would be interpreted in the same manner as the longstanding five-year rule, which (still) requires only that an inherited retirement account be emptied by the end of the applicable period, without an “overlay” of annual required minimum distributions.
Instead, the proposed regulations created two classes of non-EDBs, allowing one class — those who inherit a retirement account prior to the time the deceased owner had reached his required beginning date, or RBD — to simply empty the inherited account at any time prior to the end of the tenth year, much like the existing operation of the five-year rule.
However, the proposed regulations require a second class of non-EDBs — those who inherit a retirement account after the deceased owner had reached his RBD— to not only empty the inherited account by the end of the tenth year, but to also take annual RMD’s based on that beneficiary’s life expectancy, thereby overlaying the ten-year distribution rule with the annual RMD rule.
As for EDB’s — who, as noted are still permitted to use the highly favorable lifetime stretch — the proposed regulations, very surprisingly, would allow EDBs to opt out of using the lifetime stretch and to instead opt for the 10-year distribution period, with no annual RMDs — but only in cases where the deceased owner dies before reaching his RBD.
When might it be preferable for an EDB to opt out of using the lifetime stretch, with its requirement of annual RMDs? Perhaps if one has inherited a Roth IRA (which, by definition, has no RBD) and does not want to take annual distributions during the first nine years in order to allow for a maximum amount of tax-free compound growth. Or perhaps when the beneficiary is extremely elderly and has no need for RMD distributions, and who would otherwise be subject to required annual distributions in excess of 10% or more of the account’s value that may be subject to high marginal tax rates.
SECURE legislation has made tax, estate and financial planning more complex, and coordination in these areas more important, as the costs to both retirement account owners and their eventual beneficiaries from insufficient planning in any of these areas will be high. This is particularly true given that IRAs (and other tax-deferred retirement accounts) are now, on an intergenerational, after-tax basis, worth less — perhaps much less — than in the pre-SECURE era, while Roth IRAs and stepped-up assets are relatively more valuable. The higher the marginal tax bracket of the non-EDB account beneficiary relative to the account owner, the greater this differential is likely to be.
The result will be more lifetime Roth conversions and a greater level of spending down in retirement of IRA accounts, marginal tax rates from intended beneficiaries may need to be considered to a far greater degree than before and the estate plan may need greater built-in flexibility to accommodate that and other considerations in order to maximize/equalize the- after-tax value of inheritances. Non-EDBs will also require more tax planning in terms of the tax-efficient timing of retirement account distributions.
Michael Zaidlin presented “The 2019 Secure Act — Issues and Strategies” to the MCECP membership in 2020. He is the founder of Madrone Investment Advisory, LLCinvestment and financial planning firm based in San Rafael.
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