Traditional and Roth IRAs are now undergoing a pretty significant change due to the passing of the SECURE Act late in 2019. There are four main points that both account owners and beneficiaries should be made aware of that went into effect beginning January 1, 2020:
- Age of Required Minimum Distributions: Required minimum distributions, or RMDs, will now begin at the age of 72. Previously RMDs were required to be taken when the owner turned 70 ½. This allows for the benefit of deferring distributions, and therefore taxes due on withdrawals for another year and a half. However, if owners are already receiving RMDs, they will have to continue to take RMDs and cannot delay them until 72.
- Elimination of IRA Contribution Age Limit: Previously, account owners were only able to contribute to an IRA until the age of 70 ½, but under the SECURE Act, owners can contribute to an IRA even after 70 ½, provided they have earned employment income.
- Adoption/Birth Expenses: The new law now allows for penalty-free withdrawals of up to $5,000 to be taken for each parent (provided they both have separate accounts in their names) to spend on birth or adoption expenses.
- Inherited Retirement Accounts: Previously non-spouse beneficiaries of inherited IRAs could take RMDs over the span of their lifetime, also known as the “stretch approach,” which allowed for funds to grow tax-free for a longer period. With the new law, RMDs were eliminated, but the inherited account to non-spouse beneficiaries must be completely drained within 10 years of the IRA owner’s death, either in periodic withdrawals or in one lump sum. A few exceptions apply, including spouses, disabled individuals, individuals less than 10 years younger than the account owner (i.e., a sibling), or account owner’s minor children (until they reach the age of majority, then the 10-year limitation kicks in). These new rules only apply to accounts inherited after December 31, 2019. If the beneficiary received the IRA before that date, they could still take advantage of the stretch approach.
The new law will accelerate the income taxes paid on these IRA distributions and cut down the tax-free growth of inherited IRAs to only 10 years. This means that taxpayers could pay more in income taxes and have less time for the money to stay invested and grow. However, with some tax planning, measures could be taken to minimize taxes.
One option is for the account owner to split the IRA funds amongst multiple beneficiaries, which would result in less tax being paid on withdrawals because the account balances would be smaller.
Another option is to name a trust as the beneficiary. Certain types of trusts, such as an accumulation or discretionary trust, can be beneficial because they allow the RMDs to remain in the trust and grow. Also, trustees are allowed to distribute the funds beyond the new 10-year limit.
Lastly, consider converting a traditional IRA to a Roth IRA, especially if the account holder is currently in a lower income tax bracket. This would allow the account owner to pay taxes when the conversion takes place, but all subsequent withdrawals by the beneficiaries would be tax-free.
Consider consulting your tax planning team to compare each strategy's pros and cons, which could result in significant tax savings for future IRA beneficiaries.