What is the 10 Year IRA Rule?
If you’re set to inherit an IRA account, you must understand the laws surrounding inherited IRA. This is especially true given specific changes that have come about since implementing the SECURE Act in December 2019 – the biggest one being the 10-year rule.
The new rules introduced recently affect the required minimum distribution (RMD), the minimum amount you need to withdraw from an inherited IRA account every year. The RMD is different for different beneficiaries. If you’re wondering what these new rules are and how they could affect you, keep reading!
The SECURE Act
The SECURE Act, or the Setting Every Community Up for Retirement Enhancement (Secure) Act, was passed in December 2019 and went into effect on 1st January 2020. This Act aimed to change rules about inherited retirement accounts. It’s crucial to know these rules because you can end up getting taxed quite a bit on your inheritance without a proper understanding.
Under the SECURE Act, nearly anyone inheriting an IRA account after 31st December 2019 will be subject to the 10-year rule. This rule states that the beneficiary will have to empty the IRA account within 10 years.
Beneficiaries can choose whether to withdraw small sums from the account over time or one lump-sum amount at the end of the 10 years. Regardless of choice, beneficiaries will need to pay income taxes every time they make a withdrawal.
There are exceptions to the rule. The 10-year rule does not apply to eligible designated beneficiaries. These include spouses, disabled or ill beneficiaries, minor children, and beneficiaries less than 10 years younger than the owner.
Before this rule, beneficiaries that were not eligible designated beneficiaries could either withdraw all the amount from the IRA account within five years or take an RMD each year.
The latter option would allow beneficiaries to stretch their distributions over their whole life, allowing a significant amount of money to sit and grow in the IRA account without getting taxed. So, this new 10-year rule means that non-spouse beneficiaries (that are not eligible designated beneficiaries) are not subject to any RMD requirements.
The SECURE Act has also introduced a penalty for noncompliance to the 10-year rule. If the beneficiary fails to empty the account in 10 years, the IRS can impose a 50% penalty on the remaining amount.
How To Inherit An IRA Account Under The 10-Year Rule
One of the biggest consequences of this 10-year rule is that beneficiaries can get taxed highly. Every distribution of the IRA increases a beneficiary’s taxable income. It can even put them in a higher tax bracket – affecting their other sources of income too.
So, if you’re set to inherit an IRA account soon, here are some things to consider to make it a tax-efficient process:
1. Multiple Beneficiaries
A large IRA account being passed down to only a handful of beneficiaries means everyone will get access to a large amount of money and can get taxed at a higher rate. Comparatively, if the same account is passed down to numerous beneficiaries, each will get access to lower amounts, which means they will be subject to lower taxes.
2. Non-Spouse Beneficiary
If a spouse is not dependent on an inherited IRA account, the account holder can name a non-spouse beneficiary. For example, your children.
If an account holder leaves their IRA to a spouse who already has one, it will go to waste. The chances are that both partners’ accounts will be merged into one to be inherited by the children and subject to one 10-year clock.
Conversely, if the account holder is to pass down the IRA straight to the children (instead of the spouse), they will have 10 years to empty it. When the surviving spouse also passes away, the children will have another inherited IRA account with a completely different 10-year clock.
3. Smart Distributions
Under the new rule, beneficiaries can either delay all distributions and withdraw everything from an IRA account at the end of the 10 years or withdraw smaller amounts every year for 10 years (ideally split into 10 equal distributions).
Both methods work, but the most tax-efficient one depends on a beneficiary’s financial situation and the kind of IRA account they get. Beneficiaries with a Roth IRA, or those with a stable financial situation, may benefit from letting the money grow in the account for 10 years and then withdrawing it.
Beneficiaries can also opt to withdraw equal distributions annually. However, this is only lucrative to do so if beneficiaries choose to re-invest the amount they’re withdrawing.
Final Thoughts
Inheriting an IRA account is no easy task, given all the rules involved. Luckily, there isn’t too much technical jargon with the new SECURE Act.
If your IRA inheritance is subject to this Act, the information provided above should help you get a good hand at securing your inheritance.
References:
https://www.manning-napier.com/insights/blogs/financial-planning/secure-act-10-year-rule
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