Once upon a time, “stretch IRAs” were a popular way to pass retirement account assets to children and grandchildren. To preserve the ability to calculate required minimum distributions (RMDs) based on the beneficiary’s lifetime, any trust receiving an inherited IRA had to fit within narrow requirements. But for Roth IRAs in particular, designating an infant as beneficiary could keep assets in income tax-free accounts for over 80 years, so many clients would accept these restrictions for the tax benefits.
The SECURE Act severely curtailed the use of stretch IRAs for non-spouse beneficiaries, to offset reduced tax revenues from other retirement benefit enhancements included in the Act. Most IRAs inherited in 2020 or later by someone other than the spouse of the employee who originally owned the account must be emptied by the end of the 10th calendar year beginning after the employee’s date of death.
The 10-year rule has caused many people to rethink their strategy for using “extra” retirement savings for their children or grandchildren’s benefit. Is it worth paying a large tax bill now to convert to a Roth IRA if the funds only receive tax-free growth for 10 years after death? Are the restrictions on trust design worth getting a 10-year RMD period, versus the 5-year rule that applies to trusts that don’t qualify? The answers are highly personal to your individual and family circumstances, but the SECURE Act changed the equations for everyone.
There are a few categories of exceptions to the 10-year rule. These are called “eligible designated beneficiaries” (EDBs), though the rules are a bit different for each category:
- Beneficiaries who are disabled (based on a Social Security definition) or chronically ill (would qualify for long-term care insurance benefits, if they had a policy) can have a special needs trust funded with inherited IRAs. The trust must withdraw RMDs from the inherited IRA based on the beneficiary’s life expectancy, and pay taxes on those withdrawals if they aren’t from Roth accounts, but doesn’t have to distribute those funds out to the disabled or chronically ill beneficiary anymore. Undistributed funds can be reinvested by the trust in a non-retirement account.
- Beneficiaries who are not more than 10 years younger than the employee (think: the employee’s siblings or parents) can use their own life expectancy to calculate RMDs.
- Beneficiaries under the age of 21 who are a child of the original owner (i.e. not the employee’s grandchildren, nieces, or nephews) don’t start the 10-year clock until the year after their 21st birthday.
The IRS was tasked with writing regulations to flesh out details of the SECURE Act, and published final regulations on July 19, 2024. These regulations created some unpleasant surprises for beneficiaries subject to the 10-year rule, but also some helpful new options for revocable and testamentary trusts receiving inherited retirement assets.
Under the IRS regulations, for beneficiaries subject to the 10-year rule (including children under the age of 21!), if the employee died after their required beginning date for RMDs, they can’t just wait until the end of 10 years and distribute the account all at once. They have to calculate RMDs each year according to their own life expectancy and take at least that amount out of the inherited IRA(s) each year, until the end of year 10 when the rest of the balance must come out. (This does not apply to Roth accounts—Roth distributions can come out in lump sum at the end of year 10.)
Is this going to be a problem for young heirs? Thankfully, the IRS took this into account in the final regulations and blessed two options for handling RMDs that are required to be taken on behalf of minors and young adults.
- A trust can distribute RMDs to a custodial account (such as an UTMA), or use them to make payments on behalf of a beneficiary (such as paying health or education costs) and still qualify as a conduit trust. This is helpful both for minors and for special needs trust beneficiaries.
- A trust for a young person can accumulate RMDs now, so long as it distributes the full amount of retirement funds to that beneficiary by the end of the calendar year when they turn 31.
There are also new possibilities under the final regulations for granting testamentary powers of appointment to inherited IRA beneficiaries through revocable or testamentary trusts.
This update only scratches the surface of the lengthy final rules (and new proposed rules implementing the SECURE 2.0 Act, which the IRS released the same day). If you are interested in potentially updating your will or revocable trust to make best use of the new rules for inherited retirement accounts, reach out to the lawyer in our firm with whom you normally work. Or, if you are a new client, contact H.L. Norwich at hnorwich@hugheslegacylaw.com.
