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The Rules Have Changed Under the Secure Act: The Ten-Year Rule Replaces the Life Expectancy Stretch-Out

The primary feature of a retirement plan is that it can grow tax free. But when the owner is a certain age, previously age 70 ½, but under the Secure Act effective January 1, 2020, age 72, the owner must withdraw Required Minimum Distributions (RMD). The RMD is based on the owner’s age and the IRS mortality tables. Simply put, once you hit the required age, now 72, the IRS makes you take annual distributions and the distributions are taxable as ordinary income. You can distribute more than the RMD, but all distributions are taxed as ordinary income.

The general strategy is for the retirement plan to grow tax free as long as possible and to distribute as little as possible because distributions are taxable.

A married IRA owner typically names his spouse as the primary beneficiary. When he dies, his spouse has two options. She can do a spousal rollover and make the IRA her own and begin RMDs at age 72. Or, she can make it an inherited IRA.

Regardless of the option she chooses, she must then name her own beneficiaries. If she has children, she typically names her children as primary beneficiaries. If she has no children, she typically names individuals.

The Secure Act has significantly changed the rules for IRA beneficiaries. Before the Secure Act, beneficiaries could use the Life Expectancy Rule: the inherited IRA grows tax free during the beneficiary’s lifetime, subject to annual RMDs based on life expectancy.

Let’s say you have one child and you name him as your beneficiary. When you pass away, your child’s inherited IRA could continue to grow tax free during his lifetime. This is called a “stretch-out” IRA. He could stretch out the tax-free growth over his lifetime. He would have to take RMDs based on his life expectancy, but since he is younger than you, his RMD would be much less than yours, and in most cases, his inherited IRA would grow in value despite the RMDs.

The Secure Act, however, has changed this. Instead of your son being able to stretch-out his inherited IRA over his lifetime, he now has to withdraw the entire inherited IRA within ten years. No more stretch-out. The Life Expectancy Rule has been replaced with the Ten-Year Rule. The Ten-Year Rule is easier to understand than RMDs and life expectancy, but the result is not as good. Under the Secure Act, an inherited IRA can now grow tax free for only ten years. And all distributions are still taxed as ordinary income.

The new Ten-Year Rule has no restrictions on when and how often the inherited IRA must be distributed. It just must be distributed within ten years. In theory, you would want to keep the inherited IRA intact as long as possible to grow tax free. But, if you wait ten years and take it out all at once, you will have a big tax hit. So you have to strike a balance between maximizing tax free growth and minimizing the income tax from the distributions.

If you name one beneficiary on your retirement plan, then when you pass away, your beneficiary must distribute the plan to herself within ten years. She can decide when and how much to distribute so long as she distributes it all within ten years.

What if you name multiple beneficiaries – you have three children and want to name all three as beneficiaries? When you pass away, each child could establish her own separate inherited IRA. With their own inherited IRA, each child could make her own decision about when to make distributions within the ten-year period. It wouldn’t have to be a group decision.

One child may want to take all of his funds out right away and pay the tax on his whole amount. Another may want to take periodic distributions over ten years. Another may be retiring within ten years, and she wants to take distributions after she retires when she is in a lower income tax bracket.

The Secure Act has significantly changed the how beneficiaries manage an inherited IRA. No more stretch-out IRAs over the lifetime of the beneficiary. Now the inherited IRA must all be distributed within ten years.  The Ten-Year Rule has replaced the Life Expectancy Rule. Simple enough. But not so fast. There’s more. The Secure Act has exceptions to the Ten-Year Rule. The exceptions are a new class of beneficiaries called Eligible Designated Beneficiaries.

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