Let’s Review Your IRA Beneficiary Designations

At Ackerman Capital Management, reviewing beneficiary designations is a part of our process. It is important for clients to understand whether their estate planning intentions, including all beneficiary designations, will match actual outcomes. This is especially important when it comes to Individual Retirement Accounts (IRAs). The rules regarding required distributions from inherited IRAs are complex. These complex rules can impose marginal tax rates on beneficiaries that could be as low as zero or higher than 40%.Would a beneficiary be able to stretch distributions over her life expectancy, be subjected to the 10-year rule, or required to fully distribute the IRA within 5 years?

But optimizing taxation is only one factor to consider when choosing an IRA beneficiary. Asset protection, affecting a beneficiary’s Medicare benefits, premature depletion concerns, or charitable goals should also be considered when choosing IRA beneficiaries.

This post will focus on how the SECURE Act has changed inherited IRA distribution rules. Below is a [not-so] brief explanation of the rules and highlights why it is important to review your beneficiary designations.

How the SECURE Act affects post-death IRA Distribution Rules
Prior to the SECURE Act, inherited IRA beneficiaries were only categorized as either Designated Beneficiaries or Non-Designated Beneficiaries.

Designated Beneficiaries are human beings (and see-through trusts, described below). Prior to the SECURE Act, a Designated Beneficiary’s life expectancy was used to calculate and “stretch” required minimum distributions (RMDs) over their life expectancies. But the SECURE Act has now eliminated the life expectancy stretch for most Designated Beneficiaries, who must now fully distribute an inherited IRA within ten years of the owners year of death.

Non-Designated Beneficiaries are entities or non-human or “paper” beneficiaries like estates, charities, and most trusts. Non-Designated Beneficiary distribution rules remain largely unchanged by the SECURE Act. Entities do not have life expectancies from which a stretch could be calculated; therefore, distribution rules are based on whether the inherited IRA is transferred before or after the deceased account owner’s required beginning date (RBD) for her RMDs.

The general rule for Non-Designated Beneficiaries is that if the IRA owner died before her RBD, the IRA must be fully distributed by the end of the fifth year after the owner’s death. And if the owner died on or after her RBD, the IRA has to be fully distributed at least as quickly as the deceased owner’s remaining single life expectancy. So, if the IRA owner died at age 86, the account must be distributed per the life expectancy of an 86-year-old, which is not going to be very many years.

As a practical matter, estates may want to stretch, but usually do not in order to close the estate out; or alternatively, to avoid punitive income tax rates imposed on estates. And as for charities, they generally pay no taxes and want to distribute the IRA quickly in order to reinvest or distribute the proceeds.

As for trusts, it gets a bit trickier. The default distribution rule is that trusts are deemed Non-Designated Beneficiaries and subject to the 5-year or decedent’s life expectancy rule. But some trusts may qualify as “See-Through” Trusts, able to stretch distributions out, as described a few paragraphs down.

The SECURE Act and “Eligible” Designated Beneficiaries
Historically, distributions for Designated Beneficiaries were subdivided into rules for surviving spouses and another set of rules for all other Non-Spouse Designated Beneficiaries. That has changed. Under the SECURE Act, there are now Designated Beneficiaries and “Eligible” Designated Beneficiaries. Eligible Designated Beneficiaries still enjoy the ability to stretch. Eligible Designated Beneficiaries are as follows:

  • IRA owner’s spouse;
  • A disabled person as defined under IRC 72(m)(7);
  • A chronically ill person as defined under IRC 7702B(c)(2);
  • Any person who is not more than 10 years younger than the decedent; or
  • Minor children of the decedent (until they reach age of majority).

Spouse as Eligible Designated Beneficiary
If the IRA owner’s surviving spouse is the Eligible Designated Beneficiary, she may choose to remain a beneficiary of an inherited IRA or roll it into her own IRA. If she chooses to remain the Eligible Designated Beneficiary, she will not have to take RMDs until the year that the deceased spouse would have reached age 72; and if the surviving spouse is under 59 ½, she would be able to take distributions without being subjected to early withdrawal penalties. However, if she is over 59 ½ when the IRA is inherited, she may want to roll it into her own name so she has the ability to postpone RMDs until she is 72—and with a lower RMD as calculated under the uniform table for joint life expectancies. In addition, the rollover would enable her to name her own beneficiaries, but they would be subject to the 10-year distribution rule described below.

Distribution Rules for Eligible Designated Beneficiaries who are Disabled or Chronically Ill
The Internal Revenue Code §72(m)(7) defines a disabled person as “an individual [who] is unable to engage in any substantial gainful activity by reason of medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” This means that a disabled person who is able to work at all would be ineligible for stretching the inherited IRA beyond 10 years. The Internal Revenue Code §7702B(c)(2) defines chronically ill persons as “unable to perform at least two of six daily living activities for an indefinite [period] which is reasonably expected to be lengthy[.]” Here again, a very restrictive standard. If that standard isn’t met, the inherited IRA must be fully distributed within the 10-year rule.

Distribution Rules for Eligible Designated Beneficiaries who are Minor Children of the IRA Owner
Minor children of the account owner are able to stretch the RMDs, but only until they reach age 18. When they reach age 18, the 10-year rule kicks in and they must fully distribute the account by the end of the 10th year after the child reached age 18. One caveat to this rule: If the child is enrolled in school, including college or post-graduate studies, she may be able to stretch the RMDs of an inherited IRA until reaching age 26. At 26, regardless of where she may be in her educational pursuit, the 10-year rule would then kick in.

Distribution Rules for all other Designated Beneficiaries
All other [non-eligible] Designated Beneficiaries who inherit an IRA must distribute it by the end of the 10th year after the year of the original owner’s death. Note that there are no RMDs per year during that period. The Designated Beneficiary could conceivably distribute all of it as one lump sum in year 10 or in year 1, or any combination in between. The only requirement is that the account is fully distributed at by the end of the 10th year after the year of the original owner’s death.

Trusts as Designated Beneficiaries
If you have a trust named as a beneficiary of your IRA, it is important to review the terms of the trust and determine how that trust would be impacted under the SECURE Act’s distribution rules. As a general rule, trusts are Non-Designated Beneficiaries and therefore subject to the 5-year rule. However, certain trusts, deemed “see-through” trusts, can qualify as Designated Beneficiaries and the 10-year rule, and some see-through trusts may even qualify as Eligible Designated Beneficiaries, allowing distributions to be stretched over the trust beneficiary’s life expectancy. A trust qualifies as a see-through trust if it satisfies four prongs under Treasury Regulation 1.401(a)(9):

  • Valid under state law;
  • Irrevocable upon the retirement account owner’s death (Do not name a joint revocable trust! Create a trust solely for the IRA.);
  • Contain identifiable beneficiaries; and
  • The trust document, or a certified trust summary and list of beneficiaries, is submitted to the IRA custodian or plan administrator by October 31st following the year of death.

When the trust meets the four prongs above, we are able to “see through” to the oldest beneficiary. Before the SECURE Act that mattered as the oldest beneficiary’s single life expectancy was used to calculate RMDs. After the SECURE Act, the 10-year rule is imposed on all designated beneficiaries regardless of age.

Some see-through trusts, called “conduit” trusts, trusts that must pass RMDs through to the trust beneficiary, may qualify for stretch treatment so long as the trust’s sole income beneficiary is an Eligible Designated Beneficiary. Where an IRA owner has more than one Eligible Designated Beneficiary, she wants to name in a Conduit Trust, best practice would be to have a conduit trust for each EDB.

If a conduit trust is drafted such that the trustee is allowed to distribute only annual RMDs, the trustee may be precluded from distributing anything until the end of the 10-year post-death period, which would technically be the first and only annual RMD, and require the entire trust to be distributed at one time and at ordinary income tax rates.

“Discretionary” trusts, trusts where the trustee has discretion as to distribute income or not, will likely not qualify for stretch treatment because the remainder beneficiaries will not be Eligible Designated Beneficiaries.  The SECURE Act does include an Applicable Multi-Beneficiary provision for trusts that have multiple Designated Beneficiaries where at least one is chronically ill or disabled and would otherwise qualify as an Eligible Designated Beneficiary. Those beneficiaries may be able to stretch RMDs per their life expectancy.

Final Note on Roth IRAs
Inherited Roth IRAs are subject to the same rules above. But with Roth IRAs, income tax is generally a non-issue. But there is at least one Roth-specific rule to be aware of: the 5-year contribution rule under IRC Section 408A(d)(2)(B)). In order for the growth portion of a Roth distribution to be tax free, 5 tax years must pass from when the first contribution is made until the first distribution. That applies to the original account owner and any her beneficiaries. Now, under Treasury Regulation 1.408A-6, Q&A-2, the clock starts when contribution or conversion is made to any Roth IRA the owner may hold. There is not a new 5-year clock for each Roth contribution, nor for each Roth account that is held. So once the 5-year requirement has been satisfied, it has been satisfied for good.

For questions or comments reach out by email.
Keith A. Pillers, JD, CFP®, CIMA®, CPWA®
Director of Wealth Management


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