RMDs on Inherited Retirement Accounts in the Age of the SECURE Act

Tom Fridrich, Senior Wealth Planner 

Once upon a time, people would put money in their 401(k) or IRA accounts and know that – should their retirement savings outlive them – their loved ones would inherit the rest and all would essentially be well. 

 But then the SECURE Act went into effect on January 1, 2020, and the story changed.  

Today, someone who inherits money that’s sitting in a 401(k) or a traditional IRA could also get another, less welcome gift: higher taxes. 

How Did the SECURE Act Affect Inherited Retirement Accounts?

Under previous rules, inherited IRAs and 401(k)s could often be stretched out to provide income over the life of the beneficiary. This aptly named “stretch strategy” could be a very powerful tax benefit for loved ones. It also helped minimize the tax impact of inherited accounts. 

However, the SECURE Act effectively eliminated the stretch strategy by requiring that all inherited IRAs and 401(k)s must be distributed within 10 years after the death of the owner. This rule doesn’t apply to spouses, disabled and chronically ill individuals, individuals less than 10 years younger (or older than) the account owner or minor children of the account owner. But for essentially everyone else, it amounts to a potentially hefty RMD with a 10-year window – which can cause some less-than-ideal tax scenarios. 

Thankfully, there are ways that retirement plan owners can help ease the pain. Here are four that you can consider. 

Convert the Accounts to a Roth IRA

Contributions to traditional IRAs and 401(k)s are made on a pre-tax basis and investment earnings are not taxed until they’re distributed. For Roth IRAs, the opposite is true: Funds were already taxed before going into the account, and then distributed tax-free. Your earnings from a Roth IRA are also potentially received tax-free as long as they are considered qualified withdrawals.   

You can work with your financial advisor or directly with the custodian of your IRA to complete a Roth conversion, but keep in mind that a Roth conversion creates taxable income. This additional income could create higher taxes for you compared to what you would have experienced if you had not done the conversion 

When done right, this can be a very valuable tax planning strategy. But you need to plan ahead: The goal is to convert during years when you have the least income to avoid bumping yourself into a higher tax bracket. 

Convert to a Life Insurance Policy

The benefits of this strategy are similar to a Roth IRA conversion, and the concept is simple to understand. You can take a distribution from your IRA or 401(k) to purchase a life insurance policy that can offer a guaranteed – and tax-free – death benefit for your beneficiaries. This planning tactic also reduces the size of your retirement account or IRA, which is a good thing if you are trying to reduce the size of the taxable inheritance your loved ones receive. But you should ensure you have enough money to make it through retirement without these funds. 

Another advantage of this approach is that the death benefit doesn’t have the 10-year distribution requirement that comes with the Roth strategy. You can choose to have the death benefit distributed directly to your beneficiaries in a lump sum, or you could name a trust as beneficiary and include stipulations for when and how it’s distributed. 

The earlier you implement this strategy, the better. Life insurance becomes more expensive the older you get. There’s also a chance you could have a health setback that renders you altogether uninsurable. However, you should wait until you can take distributions from your accounts without incurring any penalties – usually after age 59½. 

It’s also important to pick the right policy. This isn’t the time for a term policy that you’re likely to outlive. On the flip side, you probably don’t need expensive add-ins such as built-in cash value. Consider permanent life insurance policy that provides a guaranteed death benefit up to age 90 or 95. 

Utilize Qualified Charitable Distributions (QCDs)

This strategy doesn’t directly affect your heirs, but it is a way to help draw down your accounts in a tax-advantaged manner. Here’s how it works.  

You must direct your account custodian to send a QCD directly to a qualified charity of your choosing. The QCD satisfies your annual requirement to take a required minimum distribution from your retirement accounts. This can start as soon as you are age 70½, and you can give up to $100,000 a year. You won’t get to deduct these gifts on your tax return, but you also won’t need to report it as taxable income the way you would with a standard distribution. 

 Side note: If you’re a retiree who is already making charitable donations and you take the standard deduction on your annual tax return, you might want to take a close look at this strategy, as it gives you a more tax-beneficial way to give. 

Create a Charitable Remainder Trust (CRT)

Charitable remainder trusts (CRTs) can also provide a potential benefit under the new rules. A CRT is an irrevocable trust that generates a potential income stream for you, as the donor to the CRT, or other beneficiaries, with the remainder of the donated assets going to charity. 

• Lifetime CRT: You can choose to transfer your 401(k) or IRA into a CRT while you’re still alive and have it pay out to you during your lifetime. After you pass away, those income payments would then be made to your named beneficiaries. Upon their death or at the end of the stated term (10 years, for example), the remaining assets would pass to the charity. In terms of tax obligations, you would initially get a deduction for the gift, but you would have to report the income received back from the trust.
   
• CRT as your beneficiary: In this option, the CRT would be named the beneficiary of your IRA or 401(k) account. After your death, the CRT would pay out to the CRT income beneficiaries for the term of the trust – this could be their lifetime or a set amount of time, no longer than 20 years.

In both scenarios, the trust would be obligated to pay your heirs over their lifetime or no more than 20 years. That is a better result than the 10-year payout. 

Something to keep in mind: This is ideally an option for the charitably inclined. But with the 10-year mandatory distribution of an IRA, a CRT could actually provide an overall better tax, charitable and wealth accumulation outcome. 

Ready to Learn More?

For a more complete breakdown of how the SECURE Act impacted inherited accounts and RMDs, download our complimentary guide Making Sense of RMDs. Then, use our handy RMD Calculator to figure out what the impact could be for you and your heirs. 

And before making any decisions about what to do with your retirement accounts, it’s best to speak to your financial advisor. They can talk through all your options and help you decide what’s right for your particular situation. 

This piece is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.

Converting from a traditional IRA to a Roth IRA is a taxable event.

A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty.