The Ten-Year Rule Replaces the Life Expectancy Stretch-Out
The primary feature of a retirement plan is that it can grow tax free. But when the owner is a certain age, previously age 70 ½, but under the Secure Act effective January 1, 2020, age 72, the owner must withdraw Required Minimum Distributions (RMD). The RMD is based on the owner’s age and the IRS mortality tables. Simply put, once you hit the required age, now 72, the IRS makes you take annual distributions, and the distributions are taxable as ordinary income. You can distribute more than the RMD, but all distributions are taxed as ordinary income. The more you take out, the bigger your tax hit.
The general strategy is for the retirement plan to grow tax free as long as possible and to distribute as little as possible because distributions are taxable.
A married IRA owner typically names his spouse as the primary beneficiary. When he dies, his spouse has two options. She can do a spousal rollover, and make the IRA her own and begin RMDs at age 72. Or, she can make it an inherited IRA.
Regardless of the option she chooses, she must then name her own beneficiaries. If she has children, she typically names her children as primary beneficiaries. If she has no children, she typically names other individuals.
The Secure Act has significantly changed the rules for IRA beneficiaries. Before the Secure Act, beneficiaries could use the Life Expectancy Rule: the inherited IRA grows tax free during the beneficiary’s lifetime, subject to annual RMDs based on the beneficiary’s life expectancy.
IRA Beneficiary Example
Let’s say you have one child and you name him as your beneficiary. When you pass away, your child’s inherited IRA could continue to grow tax free during his lifetime. This is called a “stretch-out” IRA. He could stretch out the tax-free growth over his lifetime. He would have to take RMDs based on his life expectancy, but since he is younger than you, his RMD would be much less than yours, and in most cases, his inherited IRA would grow in value despite the RMDs.
The Secure Act, however, has changed this. Instead of your son being able to stretch-out his inherited IRA over his lifetime, he now has to withdraw the entire inherited IRA within ten years. No more stretch-out. The Life Expectancy Rule has been replaced with the Ten-Year Rule. The Ten-Year Rule is easier to understand than RMDs and life expectancy, but the result is not as good. Under the Secure Act, an inherited IRA can now grow tax free for only ten years. And all distributions are still taxed as ordinary income.
The new Ten-Year Rule has no restrictions on when and how often the inherited IRA must be distributed. It just must be distributed within ten years. In theory, you would want to keep the inherited IRA intact as long as possible to grow tax free. But, if you wait ten years and take it out all at once, you will have a big tax hit. So you have to strike a balance between maximizing tax free growth and minimizing the income tax from the distributions.
If you name one beneficiary on your retirement plan, then when you pass away, your beneficiary must distribute the plan to herself within ten years. She can decide when and how much to distribute so long as she distributes it all within ten years.
What if you name multiple beneficiaries – you have three children and want to name all three as beneficiaries? When you pass away, each child could establish her own separate inherited IRA. With their own inherited IRA, each child could make her own decision about when to make distributions within the ten-year period. It wouldn’t have to be a group decision.
One child may want to take all of his funds out right away and pay the tax on his whole amount. Another may want to take periodic distributions over ten years. Another may be retiring within ten years, and she wants to take distributions after she retires when she is in a lower income tax bracket.
The Secure Act has significantly changed how beneficiaries manage an inherited IRA. No more stretch-out IRAs over the lifetime of the beneficiary. Now the inherited IRA must all be distributed within ten years.
The Ten-Year Rule has replaced the Life Expectancy Rule. Simple enough. But not so fast. There’s more. The Secure Act has exceptions to the Ten-Year Rule. The exceptions are a new class of beneficiaries called Eligible Designated Beneficiaries.
Secure Act Eligible Designated Beneficiaries
The Secure Act changes this. Now the beneficiary must distribute all of the IRA within ten years. There are no Required Minimum Distributions. The beneficiary can choose when to take distributions, but the IRA must all be distributed within ten years. Tax-free growth now ends within ten years – but not in all cases.
The Secure Act carves out exceptions to the Ten-Year Rule. These exceptions are called Eligible Designated Beneficiaries. Eligible Designated Beneficiaries can use the Life Expectancy Rule and keep their inherited IRA growing tax free beyond ten years, subject to Required Minimum Distributions.
The Eligible Designated Beneficiaries are:
- Surviving Spouse
- Children “under the age of majority”
- Chronically ill
- A person not more than ten years younger than the Employee
The Secure Act did not change the surviving spouse’s options to roll-over the deceased spouse’s IRA and make it her own or to make it an inherited IRA subject to RMD under the old Life Expectancy Rule.
Children Under the Age of Majority
There are two requirements for this exception. First, the child beneficiary must be a child of the retirement plan owner, and second, the child must not have reached the age of majority. If both requirements are met, the child beneficiary can use the Life Expectancy Rule until she hits the age of majority. But once at the age of majority, she is no longer considered an Eligible Designated Beneficiary, and she will have to use the Ten-Year Rule.
The Secure Act age does not clearly define age of majority. Most say it is age 18, or in some states, age 21. Some say it could be up to age 26 if the child has not completed a specified course of education. This should be sorted out in upcoming regulations.
A disabled person is defined as: “someone unable to engage in any substantial gainful activity by reason of any medical determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” The disabled person will have to show proof of the disability. If shown to be disabled, the beneficiary can use the Life Expectancy Rule.
A chronically ill person is someone who has been certified by a licensed health care practitioner as:
- Unable to do at least two activities of daily living for at least 90 days because of loss of functional capacity; or
- Requiring supervision to protect themselves from health and safety threats.
If chronically ill, the beneficiary can use the Life Expectancy Rule.
Person Not More Than Ten Years Younger Than the Employee
A beneficiary who is no more than ten years younger than the employee can use the Life Expectancy Rule.
The Secure Act carve outs to the Ten Year Rule for Eligible Designated Beneficiaries can be very significant for those who qualify.
But wait, there’s more.
Now that the Secure Act has been law for two years, the U.S. Treasury is now figuring out how it will interpret the new law.
February 2022 Secure Act Proposed Regulations
In February 2022, the U.S. Treasury issued proposed regulations. Proposed regulations are basically instructions on how the IRS will implement a law, in this case, the Secure Act.
Here are some of the highlights of the 2022 proposed regulations:
The Ten-Year Rule
- If the IRA owner dies before age 72, then the beneficiary can take distributions any time in any amount, so long as it’s all taken out within 10 years.
- However, if the IRA owner dies after age 72, then the beneficiary must take annual RMDs in years 1-9 based on the beneficiary’s life expectancy (the beneficiary could take more, but must take at least the RMD) and then take out the balance in year ten.
Naming a trust as an IRA beneficiary
- The new regulations make it easier to establish who the beneficiary of the trust is for the purpose of identifying the IRA beneficiary.
- “Conduit trusts” and “Accumulation trusts” are now adopted and accepted terms. Conduit trusts and accumulation trusts are types of trust provisions within a revocable living trust that determine how IRA distributions are to be made to the beneficiary.
With a conduit trust, anything taken out of the inherited IRA must be distributed to the beneficiary.
With an accumulation trust, the trustee has the discretion to distribute all or only a partial amount of the IRA distribution to the beneficiary. The amount not distributed, can be saved in the trust.
The new regulations officially recognize and approve conduit and accumulation trusts.
Using a Charitable Remainder Trust to Stretch-Out the Ten-Year Rule
The Secure Act’s Ten-Year Rule replaced the Stretch-Out for most IRA beneficiaries, and in most cases, it is a simpler, but worse result. Under the Secure Act, an inherited IRA now must be distributed out of its tax free growth environment within ten years. The result is less tax free growth and sooner than later higher income taxes.
But there may be a hack. A Charitable Remainder Trust (CRT) is a special type of irrevocable trust that pays a human beneficiary a certain amount, either a fixed amount or percentage amount, for a period of years or the human’s lifetime, and at the end of the payout term, the remainder balance in the trust is distributed to a charity. There are several rules that must be followed, including at least 10% of the remainder balance must go to the charity.
Depending on how the CRT is written, the age of the human beneficiary, and the amount of the IRA, the human beneficiary could net more from using a CRT as the beneficiary of the IRA than from naming the human directly as the beneficiary. The result could be as good as the old stretch-out, but even better because the charity also wins.
You need to run the numbers to see if this is a good solution for you. If you are interested in using a CRT for your IRA, let us know. We can help you decide if it is a good solution.
The Secure Act is now the law, and the IRS and attorneys and financial advisors are still sorting it out. Two years in, the law appears to be better in some ways and worse in some ways. The Ten-Year rule is simpler than the Stretch-Out rule, but overall not as good for investment growth and taxes. And it is still complicated.
If you need help working out how to name your IRA beneficiaries in relation to your estate plan, let us know and we’d be glad to help.