As is generally well-understood, retirement accounts such as IRAs and Section 401(k) plans are subject to mandatory distribution requirements at some point, either during the owner’s lifetime or after his or her death by the beneficiary (ies) of the account. In “retirement language”, these requirements are known as the “required minimum distribution” (RMD) rules. Such rules operate to prevent owners of retirement plan accounts from experiencing the tax benefits associated with tax-deferred plans forever. RMDs are an annual calculation and require looking back at the previous year account balance on December 31st, then dividing such balance by an applicable divisor obtained from one of three life expectancy tables provided by the IRS. Most financial advisors can compute the amount of client’s RMD, if applicable, for a client; however, T.D. Ameritrade also provides the required amount to the advisor in its VEO One software. Beginning in 2020, the age at which time distributions must begin is by April 1st of the year following the year in which the owner of the account turns age 72. (Note that this required beginning date was extended by the SECURE Act 2.0 to April 1st of the year following the year in which the owner of the account turns age 73, beginning in 2023. The Act also includes an automatic increase to age 75 by the year 2033.)
As noted, the RMD rules also apply to post-death distributions from an IRA, including a Roth IRA, as well as employer-sponsored retirement plans, such as the Section 401(k) plan. However, the rules for distributing the proceeds from the owner’s account, popularly referred to as an “inherited IRA”, also changes beginning in 2020. As a result, anyone who dies before January 1, 2020, and any existing inherited IRAs would fall under previous RMD rules. Anyone who dies on or after January 1, 2020, falls under another set of rules brought about by the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) of 2020. Prior to the SECURE Act, the determining factor is if the account owner died before or after the age of 70.5 and had previously begun RMDs prior to death. Another primary factor is the beneficiary’s relationship to the account owner (that is, whether there is a “designated beneficiary” of the account). After the SECURE Act, the before-or-after age factor determining the requirement of RMDs was repealed, so that now the beneficiary’s relationship to the account owner is pre-eminent. In addition, a new class of “designated beneficiary”, known as an “eligible designated beneficiary” (or “EDB”) was added to the rules and applies to IRAs inherited in the year 2020 and afterward. Chief among this class of new EDBs is the surviving spouse of the IRA owner or 401(k) participant. A non-spouse beneficiary, such as an adult child, of an IRA or 401(k) is separated out from an EDB as a “designated” or “non-eligible” beneficiary and may no longer “stretch” the inherited IRA proceeds over his or her life expectancy as under previous rules. Rather, the non-spouse must now distribute the inherited proceeds over no longer than a 10-year period following the year of the owner’s death. (Note that a Table showing the allowable options for each type of beneficiary beginning in the year 2020 is included at the end of this blog.)
Let’s look at an example involving Carol and her father both before and after the new SECURE Act provisions (or before and on or after January 1, 2020): Assume Carol inherits her father, Ted’s, $500,000 IRA (end of 2018 balance) in the year 2019. Ted died October 30, 2019 and would have been age 75 by the end of the year. Ted had begun RMDs as of his date of death. Carol is age 50 at the end of 2019. As a result, Carol must take a RMD for Ted’s IRA based on Ted’s remaining life expectancy as determined using Table III from the IRS or a divisor of 22.9 years. This means that she must take a RMD of $21,834.06 in 2019 ($500,000 divided by 22.9). In 2020, the RMD would switch to Carol’s life expectancy divisor using Table I from the IRS or 33.3 years for a beneficiary age 51 at the end of 2020. Assuming the account had declined at the end of 2019 to $400,000, Carol’s RMD in 2020 would be $12,012.01. (Note that the pre-SECURE Act provisions, including Carol’s ability to “stretch” Ted’s IRA is “grandfathered in”.) Finally, in 2021, Carol would reduce the 33.3 factor used in 2020 by one or 32.3 (33.3 less 1) to determine the correct divisor. Operationally, under the pre-SECURE Act provisions, the life expectancy for a non-spouse inheriting an IRA where distributions had already begun at the decedent’s death is fixed the year after the decedent’s date of death.
Now compare the result of Carol inheriting the IRA from Ted if he had died in the year 2020, with the inherited IRA subject to the SECURE Act provisions. First of all, it makes no difference whether Ted, the decedent, had begun RMDs as of his date of death. The only determinative factor is the status of the beneficiary: here Carol, as a legally competent adult child, is classified as a (“ non-eligible”) “designated beneficiary” for RMD purposes. As a result, she is not permitted to “stretch” the IRA and has only 10 years beginning in 2021 to withdraw the full amount of Ted’s IRA account balance. For example, Carol now must spread the entire $500,000 inherited IRA account balance over 10 years instead of 33.3 years. Accordingly, Carol’s 2021 RMD is now $50,000 under the SECURE Act rules and not $12,012.01 as under pre-SECURE Act rules. Additionally, the new rules reduce the amount of time that the account balance in Ted’s IRA can stay invested and grow in a tax-deferred manner.
Finally, it is interesting to note that the IRA announced new life expectancy Tables (Table I, II, and III) in November of 2020, reflecting recent life expectancy gains experienced by most individuals. The Tables will take effect beginning in the year 2022. However, generally, the Tables are only effective for lifetime distributions from an IRA and employer-sponsored retirement plans and do not impact the maximum 10-year payout for non-spouse beneficiaries of an inherited IRA.
Following is a Table outlining distribution options for inheriting retirement or IRA proceeds beginning in the year 2020.
DISTRIBUTION OPTIONS FOR INHERITING
RETIREMENT OR IRA PROCEEDS
(BEGINNING IN 2020)*
*Subsequent to passage of Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) and SECURE Act 2.0 of 2022.
