Selecting beneficiaries is one of the key building blocks of estate planning: Without the right name on the right dotted line, assets can wind up in the hands of those whom the deceased did not intend to receive them. All assets need the correct beneficiary or beneficiaries, usually dictated by a will.
An individual who inherits the assets from the original owner's individual retirement account (IRA) is referred to as the first-generation beneficiary or original beneficiary. If the first-generation beneficiary subsequently dies, their designated beneficiary is the second-generation beneficiary or successor beneficiary. Whether the original beneficiary of an IRA can name a successor beneficiary is determined by the provisions of the IRA plan document.
Sometimes overlooked by the non-spousal recipient of an inherited IRA is the task of naming beneficiaries themselves. In fact, IRA holders could not bequeath this asset to beneficiaries until as recently as 20 years ago, when the IRS green-lit IRAs to potentially pass through multiple “generations” of holders—all the while growing tax-deferred.
- Non-spouse beneficiaries cannot roll the inherited IRA into their own IRA, nor can they contribute to an inherited IRA.
- After January 1, 2020, most non-spouse beneficiaries will have to deplete the inherited IRA within the ten-year payout time frame set forth by the SECURE Act.
- Inherited IRAs subject to the ten-year payout no longer have required minimum distributions to take per year, but the entire balance must be depleted by the end of the ten-year period.
Naming IRA Beneficiaries
After inheriting an IRA, a beneficiary’s naming of their own beneficiary or beneficiaries is just as important for non-spouses (and spouses) as it was for the original owner of the account. Also, as with the original owner of the IRA, beneficiary designations on the IRA form supersede the instructions of a will: Review and, if necessary, update the new beneficiaries' list annually or at least every few years.
An inherited IRA must also be renamed to distinguish it as an inherited IRA and to identify the original account holder and the inheriting beneficiary. For example, “(name of original IRA owner) deceased (original owner’s date of death) for the benefit of (name of beneficiary).” Another example might be, “(name of deceased and date of death) Inherited IRA for benefit of (FBO) (name of beneficiary).”
Inherited IRAs: Old Rules
Before the SECURE Act, non-spousal beneficiaries of IRAs had the ability to "stretch" IRA distributions over multiple generations. It was an effective wealth transfer method that minimized taxes. Inherited IRAs had required minimum distributions (RMDs) that had to be taken every year, based on the life expectancy of the person who inherited the IRA. This was beneficial for younger beneficiaries who had a long remaining life expectancy, as they could "stretch" the length of time they had to take IRA distributions while allowing the remainder to grow tax-free.
The SECURE Act has eliminated the practice of stretch IRAs, which allowed an IRA to be passed down for generations.
A beneficiary could always take more than the RMD. However, it would not make sense from a tax-planning perspective to take more than the minimum required in the beneficiary's prime earning years when they were in a high tax bracket. “This may cause their total taxable income to increase substantially—and could push them into the highest income tax brackets,” says Bruce Primeau, CPA, president of Summit Wealth Advocates, Prior Lake, Minn.
If an original beneficiary died prior to depleting the full inherited IRA, the successor beneficiary was able to "step into the shoes" of the original beneficiary. They could continue to take the RMD each year based on the original beneficiary's remaining life expectancy. Through this method, the "stretch" could continue for generations.
Under previous law, Primeau note, the person inheriting that IRA must begin taking required minimum distributions by Dec. 31 of the year after the year of the original owner’s death. “One other piece of advice for those inheriting those IRA dollars, assuming that inheritance is substantial: Consider getting a tax projection immediately and, if possible, increase the contribution rate to their 401(k), 403(b), or another retirement plan to the maximum so they can shelter some of those RMD dollars from taxes.”
SECURE Act Changes: Non-Spouse Beneficiaries and Successor Beneficiaries
The SECURE Act passed as part of two year-end spending bills and signed into law on Dec. 20, 2019, significantly changed the rules for inherited IRAs for an IRA owner who passes away January 1, 2020, or later. One major change ended the practice of stretch IRAs, in which required minimum distributions could be extended over the lifetime of a non-spousal beneficiary and could be passed along to a second-generation beneficiary.
Under the new legislation, beneficiaries are classified as one of three different categories: eligible designated beneficiaries (EDBs), designated beneficiaries (DBs), and those not considered designated beneficiaries. Eligible designated beneficiaries (EDBs) are anyone designated by the IRA who is:
- His or her spouse
- Minor children
- A chronically ill individual
- A disabled individual
- Someone not more than 10 years younger than the IRA owner
Non-person entities such as trusts, charities, and estates are in the third category, not classified as designated beneficiaries. Most non-spouse beneficiaries will, therefore, fall into the second category of designated beneficiaries. This includes most adult children.
Individuals in the second category, including most non-spouse beneficiaries, have to withdraw all inherited IRA funds within 10 years of the death of the original account holder. Additionally, second-generation beneficiaries who inherit in 2020 or later are no longer able to "stretch" their distributions, even if the original IRA owner passed away prior to 2020. They will instead be subject to the ten-year payout rules.
Non-spouse beneficiaries cannot roll the inherited IRA into their own IRA nor can they contribute to an inherited IRA. Beneficiaries pay no early withdrawal penalty on the distributions (even if the beneficiaries are younger than 59½), but they do pay income tax on withdrawals from inherited traditional IRAs. Withdrawals of contributions from inherited Roth IRAs are tax-free at any time. Earnings from an inherited Roth IRA are tax-free as long as the account was open for at least five years prior to the owner's death.
10-Year Rule and RMDs
The concept of required minimum distributions (RMDs) has also been removed under the ten-year payout rule. There is no set minimum distribution a beneficiary is required to take in any one year. Still, the entire balance in the inherited IRA must be depleted by the end of the 10-year period following the death of the IRA owner. This allows the beneficiary some flexibility to take larger distributions in years where they would be subject to lower tax brackets. However, it also limits the overall length of time that funds can grow tax-free and limits the ability to stretch the funds over many years or multiple generations.
Examples of Inherited IRAs
1) Alex passed away on February 3, 2020 and has designated as IRA beneficiary their 32-year-old grandson, Sam. Alex is not an EDB according to the SECURE Act. Therefore, Sam has to withdraw the remainder of the funds from the IRA prior to December 31, 2030.
2) Liu passed away on November 30, 2019. Prior to death, Liu named their 40-year-old niece, Chen , as beneficiary. Because this was prior to the passing of the SECURE Act, Liu was using the old IRA stretch method to take RMDs over their remaining life expectancy. Liu named an adult child, Xiao, as successor (second-generation) beneficiary.
If instead of passing away in 2019, Liu unexpectedly passes away in 2029, Chen will no longer be able to continue the stretch method. As a designated beneficiary who is not an EDB post-SECURE Act, they would have to take the remaining funds out of the IRA within 10 years, prior to December 31, 2039. There will be some flexibility to choose when to take those distributions over the following 10-year period. If Chen loses their job at any point during that 10-year period and is temporarily in a lower tax bracket, that would be the most ideal time to take a majority of the funds from a tax-planning perspective.
3) Sam passed away on April 6, 2020 and had designated Addison as the spousal IRA beneficiary. As an EDB and spouse beneficiary, Addison still has the option to take life expectancy distributions from the IRA. Addison subsequently designates their adult child, River, as successor beneficiary. If Addison subsequently dies on August 3, 2024, River will no longer have the ability to take the life expectancy method and will instead be required to deplete the remaining funds prior to December 31, 2034.
4) Cameron passed away on March 23, 2020 and designated as IRA beneficiary a nephew. A nephew is not an EDB and so must use the 10-year payout rule. The nephew then designates his sibling as successor beneficiary. If the nephew subsequently dies in 2023, prior to depleting the IRA, their sibling will be locked into the same 10-year period that started when Cameron passed away and will, therefore, have to finish withdrawing funds from the IRA by December 31, 2030.
The Bottom Line
Inherited IRAs can still be tools to build and preserve wealth. But with the elimination of the stretch IRA, that wealth cannot continue to build for decades. Check with a financial planner or estate tax expert to make sure you are getting the most from an inherited IRA. Experts will also ensure you are not setting yourself up for penalties by not following the new rules and procedures. Be sure to review any estate planning that was predicated on the use of stretch IRAs or other wealth-preservation strategies that may have changed.