James McGlynn CFA, RICP
Stretching Inherited IRA's
THE SECURE ACT, which took effect Jan. 1, 2020, made inheriting an IRA even more complicated. Before 2020, beneficiaries typically had the option of taking distributions from an inherited IRA over their lifetime, potentially squeezing many more years of tax-favored growth from these accounts.
The SECURE Act drew a new line, eliminating some beneficiaries’ ability to make use of the so-called stretch IRA. Beneficiaries now are divided into two groups. Some have to empty an inherited IRA within 10 years of the original owner’s death. Others are permitted to stretch out their withdrawals for longer, often over their estimated lifetimes.
I want to focus on this second group—called eligible designated beneficiaries—who can still defer taxable distributions for longer than 10 years. It includes more people than you might think. Under the SECURE Act, eligible designated beneficiaries include:
Chronically ill individuals
Minor children of the IRA owner
Individuals who are less than 10 years younger than the IRA owner.
Surviving spouses continue to have the most flexibility because they’re allowed either to roll over an inherited IRA into their own IRA account, and potentially delay all withdrawals until age 72, or to leave the money in the inherited IRA. The key advantage: Spouses have the flexibility to either stretch withdrawals over their own life expectancy or over the deceased account holder’s “life expectancy,” as calculated by the IRS, which could be beneficial if that happens to be longer.
Disabled and chronically ill individuals can also stretch withdrawals over either their life expectancy or the remaining life expectancy of the deceased. Unlike a spouse, however, they aren’t allowed to roll over the IRA into their own account. Instead, they must use an inherited IRA account to shelter assets until they’re withdrawn.
Minor children of the IRA owner—but not grandchildren—can stretch their withdrawals, but not for a lifetime. Their 10-year withdrawal clock starts when they reach the age of majority—which differs by state—or as late as age 26 if they’re completing their education.
Beneficiaries who are less than 10 years younger than the IRA owner can still take advantage of lifetime withdrawals. This is where it gets interesting. The “less than 10 years younger” rule happens to include any beneficiary who is older than the account owner. This means older siblings, friends or domestic partners could be entitled to stretch their IRA withdrawals over their own life expectancy.
I’ve found this aspect of the law isn’t yet widely understood. For instance, I just completed a continuing education course on the new rules for IRAs that incorrectly stated that parents and grandparents don’t qualify for lifetime distributions. They all would qualify because, presumably, they’d all be older than the original IRA owner.
Applying the same rule, cohabiting adults who are within 10 years of the deceased’s age also qualify for the stretch rules. The surviving adult would be able to take lifetime withdrawals if listed as the IRA’s sole beneficiary.
The new rules also apply to Roth IRAs, but with one additional condition, which concerns the five-year rule. If the Roth account was established less than five years before the account owner’s passing, the beneficiary must wait to withdraw assets until that requirement is met to ensure the withdrawals are tax-free. This is one more reason to establish Roth IRAs as early as possible.
Who loses out under the SECURE Act? Younger beneficiaries, such as the grandchildren of IRA owners. Before 2020, they might have stretched inherited IRA withdrawals over six or seven decades, allowing the account to enjoy enormous compound growth. Now, their inheritance must be withdrawn from the sheltering arms of an IRA in no more than 10 years. Under the new rules of the game, our grandparents are welcome to take a stretch, but not our more limber grandchildren.