The Secure Act is a landmark bill that tweaks many aspects of retirement, including one major change that could mean a bigger tax hit from inheritance accounts.
The bill was signed earlier this month, and arguably the biggest change greatly reduces the amount of time a beneficiary has to withdraw all the money out of certain inherited retirement accounts.
The new rule in the Secure Act says individuals must withdraw all funds within 10 years of inheriting an account from someone who recently died, such as individual retirement accounts (IRAs) or 401(k)s. Previously, beneficiaries could stretch those withdrawals out over their life expectancy determined by the IRS.
Eliminating these so-called “stretch IRA provisions” means beneficiaries will most likely face higher tax bills because they will have to withdraw more from funds each year, and those benefits will be taxed. It also eliminates the chance for beneficiaries who inherit these accounts, but may not need the funds, to set up a retirement account for their heirs that wouldn’t be hit with huge tax bills.
Here is an example of how the old “stretch IRA” strategy worked, per MarketWatch:
Say you inherited Grandpa Dave’s $750,000 Roth IRA when you were 40 years old. The current IRS life expectancy table says you have 43.6 years to live. You must start taking annual RMDs from the inherited account by dividing the account balance as of the end of the previous year by your remaining life expectancy as of the end of the current year.
So, your first RMD would equal the account balance as of the previous year-end divided by 43.6, which would amount to only 2.3% of the balance. Your second RMD would equal the account balance as of the end of the following year divided by 42.6, which translates to only 2.35% of the balance. And so, on until you drain the inherited Roth account.
That would give the individual in this example years of income that would be tax-advantaged. But now, that person would have to withdraw all of that $750,000 over 10 years, greatly increasing their tax burden.
This new change mostly affects individuals and estates that are well off, and some estate planners will probably have to reassess their strategies if “stretch IRAs” were part of their plans to help benefit future heirs.
Who Is Safe From the New Secure Act Inheritance Rule?
Not everyone will be affected. The new change in the Secure Act will only create RMDs for accounts of owners who die in 2020 and beyond. So if you have already inherited an account, you are safe.
The new rule also does not apply to spousal beneficiaries, disabled beneficiaries or anyone who is 10 years or less younger than the account holder who dies. That means slightly younger siblings are exempt. Minor children are also safe from the new rule, but only until they become legal adults at 18.
The Secure Act change is estimated to bring in $15.7 billion in tax revenue over the next decade, according to the Congressional Research Service. That’s a nice little tax bump, which is probably part of the reason for the change.
While the new rule will provide a new tax stream for the government, this change under the Secure Act could mean reevaluating your retirement strategy. It may be worth checking with your financial adviser or estate planner to see what you can do.