No More Stretch: SECURE Act Brings Big Changes to Inherited IRAs

One of the ways that wealth passes from generation to generation is through inherited IRAs. When it comes to these Individual Retirement Accounts, it’s important to understand that there are some new rules thanks to the December 2019 passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

One of the biggest changes is the elimination of the stretch provision for many inherited IRAs (for deaths that occur in 2020 or later). Without the stretch IRA, some beneficiaries will need to deplete their inherited accounts faster. Here’s what you need to know.

Surviving Spouse: Treat As Own IRA (Assuming the IRA)

If you’ve inherited an IRA from your spouse, you have a choice that no one else has. You can add the inherited IRA assets to your own IRA and potentially keep it growing, which may give you more money for retirement. Keep in mind it has to be the same type of IRA you inherited. For example, if your spouse had a Roth IRA, you have to transfer the money into a new or existing Roth IRA in your own name.

Adding over the inherited assets to your own IRA may help preserve any potential tax benefits, including the opportunity for tax-deferred (traditional) or tax-free (Roth) growth. Another reason to consider assuming the IRA is that you may be able to make additional contributions to help build your savings. When you assume IRA assets, then you will start taking RMD’s based on your age and when you reach your required beginning date (either age 70 1/2 or age 72, depending upon when you were born). Depending upon your beneficiary, you may also be able to take RMD’s based on joint life expectancy, which typically results in a small minimum payout than does using single life expectancy for payments. 

Once it is in your own IRA, if you want tax-free income in retirement or think your tax rate may be higher in the future, you could also consider converting your traditional IRA rollover to a Roth. Keep in mind that, depending on the type of contributions your spouse made to their IRA, you’ll have to pay taxes on the converted amount. Before converting, you might check your spouse’s past tax returns to see if they included Form 8606, which is used to report nondeductible IRA contributions. Nondeductible contributions aren’t taxable when you do a Roth conversion because taxes have already been paid on the money. If your inherited traditional IRA does not contain any nondeductible contributions and you have also not made any nondeductible contributions to your traditional IRA(s), then the full amount you convert to Roth IRA will be taxable in the year you do the conversion.

The best news is that the option for the surviving spouse to roll (sometimes called assuming the IRA) the inherited IRA into an IRA in their own name has not been changed by the SECURE Act.

Additional Alternatives for Surviving Spouses

Here are several other things a surviving spouse could do with an inherited IRA.

1. Take the life expectancy payments from an inherited (beneficiary) IRA. Instead of assuming the IRA, the IRA can be re-registered as an Inherited IRA in your name. Whether or not this makes sense for you depends on the type of IRA you have inherited (traditional or Roth), your decedent spouse’s age, and the required minimum distribution (RMD) rules.

For assets in an Inherited IRA, the surviving spouse must take periodic withdrawals (RMD’s). These RMD payments represent a minimum that must be withdrawn by the surviving spouse each year. The payment is calculated based on the life expectancy of the surviving spouse. This has NOT been changed by the SECURE Act. Surviving spouses can still take life expectancy payments, sometimes called a “Stretch IRA” payment, as long as they do so on a timely basis.

However, typically in an inherited IRA, the surviving spouse must use single life expectancy when taking the RMD’s. This single life expectancy payment might be much larger than the payment would have been had the surviving spouse “assumed the IRA” (as discussed above), and used joint life expectancy once the surviving spouse reached their RMD age. Many surviving spouses opt for assuming the IRA because of the ability to use joint life expectancy for RMD payments. In some cases, it might be beneficial for a surviving spouse beneficiary to use an inherited IRA for a limited time period and then assume the IRA later. Thus, if you are a surviving spouse beneficiary who wants to limit distributions, be sure to review and compare the amounts that must be taken, as well as the timing.

When does the spouse have to begin the RMD’s in the Inherited Account? This starting date depends upon whether the decedent spouse had already reached their own RMD age before s/he died.  

• If the decedent spouse had reached his/her RMD beginning date, then the surviving spouse must take any remaining RMD’s that the decedent spouse missed in the year of death. The surviving spouse must start taking their own RMD life expectancy payments in the year following the year of death and continue each year. Of course, the spouse can always take more.
• If the decedent spouse had NOT yet reached his/her RMD beginning date, then the spouse has two alternatives for starting their life expectancy payments, either: 
  1. By December 31 of the year following the year the original account owner died, or         
  2. By the end of the year in which the original account owner would have turned 70 1/2. But now, under the SECURE Act, the surviving spouse can wait to begin the mandatory withdrawals until the end of the year during which the account owner would have been 72. Thus, surviving spouses who have been postponing RMDs under this rule may wait even longer, if desired.
• Here are a few more considerations for Inherited IRAs based on the type of IRA the surviving spouse inherits:
  Traditional beneficiary IRA. Any distributions are generally taxable, but the 10% penalty for early withdrawals before age 59 1/2 doesn’t apply. In addition, the timing of RMDs is based on whether your spouse had already begun taking them at the time of death. If so, you have to continue taking them. If the decedent spouse had not taken their RMD in the year they died, the surviving spouse must take out the RMD for that year too, as discussed above. And remember: there’s also a 50% excess penalty for any missed RMDs. 
  Roth beneficiary IRA. Although the RMD rules are the same as a traditional beneficiary IRA, withdrawals are generally tax free if certain requirements are met. If the spouse beneficiary does not want or need these inherited Roth IRA distributions, they might consider rolling over the inherited assets into their own Roth IRA to avoid these payments as discussed above in “Assuming the IRA”.

2. Take a lump-sum or random distribution. If you have an immediate need for the money, you might decide to receive a lump-sum distribution, although you’d be giving up any tax benefits that you might get by keeping the money in an IRA (like the potential for tax-deferred or tax-free growth). Plus, if it’s a traditional IRA, you may have to pay taxes on the amount you receive, which could possibly push you into a higher tax bracket for that year. If you leave the IRA in your spouse’s name or put it into an inherited IRA, remember that you must begin periodic RMD withdrawals. If you do not, and your spouse died in 2019 or earlier, you will have to withdraw all the IRA assets within five years or face the 50% penalty. Under the SECURE Act rules, if your spouse dies in 2020 or later, the five years is increased to 10 years. Note that if you are currently using the five-year rule because the death occurred in 2019 or earlier, or if you use the 10-year rule, you do not have to take out any certain amount each year. All the money merely has to be out by the end of the appropriate 5 or 10-year period. But stay tuned in case we get more IRS guidance on how the new 10-year rule will be applied. There is some discussion that an annual payment may be required in select instances if the original account owner had been receiving RMD's and then died. Again, IRS guidance will be needed.

3. Disclaim the inherited assets. You can also refuse all or some of the money. If you do, the inherited assets will pass to the next eligible beneficiary. This could be a way for you to help someone whose financial situation may not be as solid as yours. Before the SECURE Act, it was common to try to stretch out IRA tax benefits to future generations by naming young children, grandchildren, or even great grandchildren as beneficiaries. Under the SECURE Act, big changes have been made for nonspouse beneficiaries for all deaths that occur in 2020 or later. Many must now take all the money out by the end of the 10-year period following the death. Because most of these beneficiaries will no longer be allowed to stretch these payments beyond 10 years, make sure to review your beneficiaries. Note: The decision to disclaim assets must be made within nine months of your loved one’s death.

Before moving forward with one of these distribution options, it’s a good idea to consult with a tax professional who can help you navigate the tax implications. Remember that withdrawing money from a traditional IRA adds to your income, so you’ll be taxed on it at your ordinary income rate.

Inherited IRAs for Nonspouses

The biggest change to inherited IRAs as a result of the SECURE Act is the elimination of the “stretch IRA” for most nonspouse beneficiaries. With the stretch IRA, it was possible to use your life expectancy to minimize IRA withdrawals over time. This strategy allowed beneficiaries to shelter a large portion of the inheritance from taxes. The SECURE Act gets rid of the stretch provision for many (but spouses can still use it), creating a new 10-year rule.

BEFORE the SECURE Act:

All nonspouse individual beneficiaries were able to use their life expectancy to calculate the minimum amount that had to be taken each year from the Inherited IRA. If the account owner died in 2019 or earlier, nonspouse individual beneficiaries may still continue this method.

AFTER the SECURE Act:

For deaths occurring in 2020 or later, only certain nonspouse individual beneficiaries (called “eligible beneficiaries”) may continue to use their life expectancy to calculate the minimum amount that must be withdrawn each year. These eligible beneficiaries are:

1. Chronically ill or disabled nonspouse beneficiaries.
2. Nonspouse beneficiaries not more than 10 years younger than the account owner who died.
3. A minor child of the account owner (biological child or legally adopted), but only until that child reaches the age of majority. Once reaching age of majority, the child of the original account owner will have 10 years to deplete the account.

All other nonspouse beneficiaries must use the new 10-year rule to deplete the account. This includes grandchildren and other family members who do not meet the exceptions above. 

Thus, instead of being able to stretch inherited IRA withdrawals over a lifetime, these beneficiaries have to draw down the account by the end of the 10th year following the decedent’s passing. 

You can always draw down the account faster as a beneficiary. However, the downside to getting the money faster is that you end up withdrawing larger amounts, which could have a significant impact on your tax bill if the inherited assets were in a traditional IRA, SEP IRA, or SIMPLE IRA. If the assets were in a Roth IRA, beneficiaries are not taxed on the withdrawal.

Finally, realize that inherited IRAs aren’t exempt from creditors. Although a spouse might be able to avoid having the assets in an inherited IRA taken to settle debts, a nonspouse beneficiary won’t have that luxury. It’s just one thing to keep in mind if you receive an IRA as part of your inheritance.

Pay Attention to the Details

If you have inherited a retirement account, generally you must withdraw required minimum distributions (RMDs) from the account to avoid IRS penalties. RMD amounts depend on various factors, such as the beneficiary’s age, relationship to the beneficiary, and the account value. If inherited assets have been transferred into an inherited IRA in your name, this tool may help determine how much you need to withdraw and which distribution method might work best for your unique situation.

Remember that you need to know if your loved one started taking RMDs because they had reached age 70 1/2 before 2020 or age 72 after December 31, 2019. If they were required to take RMDs, you need to keep up with them—or risk getting hit with an IRS penalty. The SECURE Act adjusts the age for RMDs to 72, but only for IRA account owners who were born on or after July 1, 1949. Some beneficiaries will have loved ones who died after taking RMDs under the old rules. If your loved one died in 2019 or earlier, you can continue to follow the rules from before the SECURE Act. It’s only for deaths in 2020 or later that you may want to check with a professional to discuss how to proceed.

If you have multiple beneficiaries on your IRA, note that the SECURE Act has left open many questions about how to handle distribution choices. IRS guidance is needed to help reset the rules for account owner deaths in 2020 or later when there are multiple primary beneficiaries.

If you know that someone plans to leave an inherited IRA to you, make sure you tend to financial matters as soon as possible—even before their death. Family members should keep up on paperwork, because incomplete or ambiguous beneficiary forms can cause problems later. In fact, if there’s a discrepancy between a beneficiary form and the will, it’s the beneficiary form that will be heeded—not the will. 

For example, if there aren’t clear beneficiaries, the IRA might just revert to the estate, which often automatically triggers the five-year rule. Under the SECURE Act, nonindividual beneficiaries, like the estate, continue with the five-year rule for mandatory distributions as long as the original account owner had not yet reached RMD age. If the account owner had reached RMD age and dies in 2020 or later, we are not yet sure what rules the estate will be subject to. We need additional guidance from the IRS on this situation. 

Bottom Line

Carefully consider the available choices when deciding what to do with an inherited IRA. Consult with a knowledgeable retirement or tax professional who can take you through the alternatives and help you potentially limit any negative tax consequences. Learn more about inherited IRAs and accounts here, where we explain the steps to smoothly transition the ownership of the inherited accounts.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.