In December 2019, Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The act includes many reforms that could make saving for retirement easier and more accessible for many Americans. But there is one potential downside: If you inherit an IRA or 401(k) from someone other than your spouse, the SECURE Act could impact your retirement savings plans or strategies to transfer wealth to future generations.
Prior to the act, if you inherited an IRA or 401(k), you could generally "stretch" your taxable distributions and tax payments out over your life expectancy.
Now, for IRAs inherited from the original owners who passed away on or after January 1, 2020, the new law requires that most beneficiaries must empty the account by the end of the 10th year following the year of the account owner's death.
If the IRA holder died on or after their Required Minimum Distribution (RMD) age, the designated beneficiary is also subject to an annual RMD in addition to the 10-year rule.1 If you have not already started taking distributions, the IRS has waived the penalty for failing to take RMDs in these instances for tax years 2020-2024.2
The exceptions
The SECURE 2.0 Act of December 2022 presents options to an individual who inherits an IRA or 401(k) from his or her late spouse. As the inheritor of the account, you may stretch out RMDs over your own projected life expectancy or over the projected life expectancy of your spouse, whichever is longer. You may also be able to stretch distributions if you fall into one of 3 other types3 of eligible designated beneficiaries (EDBs):
- A minor child (not grandchild) of the original owner4
- Someone who is not more than 10 years younger than the original owner
- Someone disabled or chronically ill (as defined under the applicable sections of the Internal Revenue Code)
If you’re eligible, stretching distributions makes sense because doing so maximizes the value of tax deferral.
4 scenarios to consider
If you're not a spouse or an EDB, then generally you must distribute all assets from the inherited IRA within 10 years of the original owner's death. How should you do this? In general, it depends on which of 4 scenarios below best describes your situation. (Your situation may differ from the scenarios listed here.) Consult a tax advisor to determine what makes sense for your individual situation.
Scenario 1: You inherit a traditional IRA or 401(k), need the income to live on in retirement, and expect your tax status or taxable income to remain constant over the next 10 years
How to withdraw
In this scenario, it's often advantageous to withdraw assets from the inherited IRA or 401(k) in equal installments over the entire 10-year period. The strategy is designed to smooth out the impact of additional taxable income and help lower the risk of bumping you into a higher marginal tax bracket by mistake.
How to invest
If you have assets other than the inherited account dedicated to the same goal, and you're willing to complicate things a bit in order to potentially reduce your total tax bill, it may be smart to invest more of your bond or cash allocation to the inherited account.
For example, say you inherited a traditional IRA worth $100,000 and you've decided to use it for your retirement goal. The assets are currently held in a mutual fund with a balanced (50% stock/50% bond) asset allocation, which is generally aligned with the asset allocation of your other assets earmarked to fund your retirement.
Assuming you are comfortable operating within your current risk profile (and won't change it as you edge closer to retirement), you might consider holding assets with lower growth potential in your inherited IRA; then you could invest remaining assets with a higher growth potential (such as stocks or equity ETFs and mutual funds) in non-inherited retirement accounts so that your total asset allocation remains 50/50. That way, you could potentially defer paying ordinary income taxes on a relatively large portion of the growth in your assets assigned to the goal for a longer period of time, as the assets in the non-inherited retirement accounts don't need to be withdrawn within the 10-year window.
Scenario 2: You inherit a Roth IRA or Roth 401(k), need the income to live on in retirement, and expect your tax status or taxable income to remain constant over the next 10 years
In this case, the better withdrawal and investment strategy is likely the opposite of that in Scenario 1.
How to withdraw
Generally, keeping assets in inherited Roth accounts for as long as possible may help you earn your highest returns because qualified withdrawals are tax-free. The most efficient withdrawal strategy would be to take a single withdrawal in year 10.3
How to invest
If you have non-Roth assets dedicated to the same goal and you're willing to complicate things a bit in order to potentially reduce your total tax bill, it may be smart to invest the inherited account with higher growth potential assets—and the remaining accounts in the goal with lower growth potential assets. That way, you can reduce your total tax bill by generating more growth in the Roth account, which is not taxed.
Scenario 3: You inherit a Roth account and, separately from this, you expect a significant change in your tax status or taxable income
What might be a significant change? Here are 2 examples:
- You are retired and, in the near future, are planning to move from a high income tax state (like California, New York, or New Jersey) to a low- or no-income tax state (like Florida, Texas, New Hampshire, or Washington)
- Your taxable income is expected to increase and meet the rest of your retirement expense needs: e.g., you expect to start receiving additional taxable income from rental real estate, business consulting, Social Security, or other sources.
How to withdraw
If you typically withdraw from a traditional IRA to meet your expenses in retirement and you expect to move to a state with lower income taxes in 5 years, then you can consider withdrawing from your inherited Roth account instead of from your traditional IRA to meet some of your retirement expenses while living in the higher income tax state. Since qualified Roth withdrawals are tax-free, withdrawing some or all of your expense needs from an inherited Roth may help you pay for your expenses while generating less taxable income.3 If your income is taxed at a higher rate today than it will be in the future, using your inherited Roth in this manner may help you lower the amount of taxes you pay throughout retirement.
Or, if you typically withdraw from a traditional IRA to meet your expenses in retirement and your taxable income is going to increase in 5 years such that your retirement expense needs will be met, it may make sense to hold off on withdrawing from your inherited Roth until you are required to do so. Since you anticipate that in the future, your traditional IRA withdrawals, combined with your additional income, will meet your full expense needs, keeping your assets invested in your inherited Roth for as long as you can may enable you to make the most of the tax-free growth that the Roth offers.3
How to invest
As in Scenario 2, if you have non-Roth assets dedicated to the same goal, it may be smart to invest the inherited account with higher growth potential assets—and the remaining assets with lower growth potential assets.
Scenario 4: You inherit a traditional IRA or 401(k) and would like to create a guaranteed income stream to disburse over a set period of time.
How to withdraw
You can transfer the inherited assets into a period-certain immediate fixed income annuity and begin receiving income immediately upon transferring. In order to satisfy the IRS's 10-year rule, the last annuity payment would need to be received no later than December 31 of the year containing the 10th anniversary of the owner's death. While payments would still be taxed as ordinary income, an annuity offers simplified, guaranteed withdrawals.
How to invest
You can make a one-time, tax-free transfer into a period-certain immediate fixed income annuity.
Talk to us
If you are the owner or inheritor of an IRA or other qualified retirement plan, you may wish to take some time to consider how the SECURE Act may impact your own retirement accounts along with your beneficiaries and reevaluate your retirement, estate planning, and gifting strategies.
Work with your financial professional to help clarify your personal and financial goals. Remember, your plans should evolve as you do.