As of January 1, 2020, the latest federal income tax law change, the “SECURE Act,” changed how inherited IRAs are handled. Before the SECURE Act, a designated beneficiary of an IRA after the owner’s death generally could stretch the distributions out over that designated beneficiary’s life expectancy.  Now, an inherited IRA must be emptied 10 years after the owner’s death (with four exceptions).

What Does the Change Mean for You?

This change dramatically impacts the basic economic calculus of inherited IRAs.  For example, under pre-SECURE Act law, a child aged 40 who inherits his/her parent’s IRA could take withdrawals from the IRA over 43.6 years.  This spread of the taxable income is reportable on a child’s 1040 potentially over a long period and it permits the IRA to grow tax free on the amount not withdrawn. An additional benefit of an inherited IRA is that a greater amount than the minimum distribution amount could be withdrawn from the account without triggering an early withdrawal penalty.  Any withdrawals, of course, would be taxable income. The combination of a long stretch and the ability to accelerate distributions, if necessary, made inherited IRAs a useful wealth transfer mechanism under pre-SECURE Act law.

The inherited IRA could be left in trust for a beneficiary and if properly constructed, the stretch could be preserved. A trust can add asset protection for the beneficiary which, for certain non-Maryland beneficiaries of inherited IRAs, may come in handy. See Clark v. Rameker, 573 U.S. 122 (2014) for an illustration of the issue. Now under the SECURE Act, the “stretch” abruptly ends in the 10th year after the participant’s death. If the trust provides that all minimum distributions be distributed to the beneficiary (a “conduit” trust), then the IRA assets all are distributed to the beneficiary under the 10-year rule.

Under the SECURE Act, a 40-year old non-disabled child would be required to withdraw the entire amount from the account by the end of the 10th year after the parent’s death.  For instance, a death in February 2020 requires emptying the account by December 31, 2030 – 10 years and 10 months after the death.  In other words, the 10-year rule is really a not-more-than-an-11-year rule.

The Four Exceptions to the 10-Year Rule

The four exceptions to the 10-year rule cover the following individuals:

  • Spouses;
  • Individuals who are less than 10-years younger than the participant (perhaps a sibling), a minor child of the participant during minority or, if in school in certain circumstances, minority could extend until the child reaches age 26;
  • A disabled beneficiary; and
  • A chronically ill beneficiary.

The exception for a minor child is limited to a child of the participant under IRC § 401(a)(9)(E)(ii)(II).  A grandchild is not included in this exception.  Thus, if a grandmother makes her grandchild the designated beneficiary of an IRA, the 10-year rule applies regardless of that grandchild’s age. This will trip up many IRA holders because the “stretch IRA” to young grandchildren was often recommended by investment advisors as a way of encouraging post-death growth of the IRA.  Obviously, under the earlier rules, the younger the designated beneficiary, the longer the IRA stayed in existence generating tax-free growth.

The SECURE Act is a dramatic change from prior law.  It is surprisingly complex and the devil is in the details.  The SECURE Act changes will impact many of your clients and when the implications of the law become widely broadcast, clients will be seeking advice from their accountants, financial advisors and (yes!) their lawyers.

The changes of the SECURE Act impact how clients should structure their estate planning. Our Maryland estate planning lawyers can help you navigate how these changes fit with your estate plan.