For many Americans, the two most valuable assets they own are their homes and their IRA or other retirement accounts. Planning on what to do with the home at death can be a challenge here in Florida, with Florida’s complicated homestead rules, but there’s usually a way to work it out. Planning on what to do with an IRA at death, however, got much more complicated because of recent federal legislation.
In 2019 Congress passed the SECURE Act, effective January 1, 2020, and in 2022 Congress passed the SECURE 2.0 Act, effective January 1, 2023. Of the two, the SECURE 2.0 Act is more benign as it prolongs the date that an IRA owner must start taking minimum distributions, increases the additional catch-up contributions for persons over 60, and reduces the penalty for not taking out the required minimum distribution if the owner corrects the error in a timely manner, among other things.
The first SECURE Act, on the other hand, upended many estate plans because it took away the ability of parents to leave their IRAs to their children who could then take out distributions from the inherited IRA over their lifetimes. Instead, as of January 1, 2020, non-qualified beneficiaries (i.e. the children) must withdraw the entire inherited IRA by the end of the tenth anniversary of the year of the parent’s death. To make matters worse, the IRS has issued proposed regulations that would require yearly distributions for most inherited IRAs over ten years instead of letting the IRA grow tax-free for ten years before cashing it out all at once.
These new rules do not apply to retirement accounts left to spouses, disabled persons, minor children (until they turn 18), or persons not more than ten years younger than the account owner, but that’s a fairly limited group of what constitutes a “qualified beneficiary.” For those who want to leave their retirement accounts to their children, special planning may be required.
Most children would be fine with a ten-year distribution period for an inherited IRA. It’s extra money each year for ten years, and extra income taxes, but unless the retirement account is very large it should not affect their tax rate. The issue arises more when the beneficiary has issues that indicate a large cash infusion in their pockets would not be a good idea, such as simple money mismanagement or something more severe like dependency or addiction issues.
For those special circumstance situations, the pre-2020 planning would normally be to leave the IRA to a trust for the child’s benefit. Minimum distributions would flow to the trust based on the child’s life expectancy, and the trustee would either disburse those funds or hold them to be used as needed for the child’s benefit. Under the new rules for a 10-year disbursement period, such trusts carry consequences.
Trusts that are required to distribute the annual distribution to the beneficiary will, perhaps, be putting more cash in the hands of the beneficiary than the parent intended. Trusts that are designed to hold onto the distributions and pay them out only as needed will incur significantly higher income taxes because trusts reach the highest income tax bracket of 37% on any income over $14,450.
It’s a common saying among tax attorneys to not let “the tax tail wag the dog,” meaning don’t make plans solely on the tax consequences if some other arrangement makes more sense. With IRAs, estate planning should focus on what’s best for the beneficiary, but the tax consequences need to be understood, too, so you can make an informed decision on how to structure your estate plan.
