How Secure Act's 10-Year Rule Creates Tax Headaches for IRA Heirs

The Setting Every Community Up for Retirement Enhancement (Secure) Act fundamentally changed the rules governing distributions from inherited retirement accounts mere months before the COVID-19 pandemic struck the U.S. Understandably, many clients put those new rules on the back burner to focus on more pressing concerns, but now clients should be reminded about the changes.

The post-Secure Act distribution requirements mean that clients should reconsider their beneficiary designations to ensure that their accounts are passed down to heirs in the most tax-efficient manner possible.

Inheriting an IRA or 401(k) under the new regime can create a number of adverse tax consequences for the beneficiary — and it’s never too early to take actions designed to ensure the best possible outcome from a tax perspective.

Post-Secure Act Distribution Rules

For clients who inherit traditional retirement accounts after Dec. 31, 2019, the “stretch” inherited IRA strategy has been sharply limited. Under the Secure Act, nearly every beneficiary who inherits a retirement account (IRAs, 401(k)s, etc.) in 2020 and beyond will have to empty the account within 10 years — and pay income tax on the distribution at ordinary income tax rates. 

Generally speaking, if the IRA beneficiary is not an “eligible designated beneficiary,” the entire account must be emptied within 10 years. Eligible designated beneficiaries (EDBs) include spouses, disabled and chronically ill beneficiaries, minor children of the account owner and beneficiaries who are less than 10 years younger than the owner. EDBs are exempt from the new rules — and can continue to empty the inherited account by taking distributions over their own life expectancy (and can stretch the tax liability over that time period).

Beneficiaries who are subject to the 10-year rule should not be required to take a distribution every year (i.e., the beneficiary can still defer taxes for 10 years and take a lump-sum distribution at the end of that period). 

Understanding the Consequences of the 10-Year Rule

The first major tax consequence of the new Secure Act inherited account rule is the penalty for noncompliance. Although the beneficiary can use discretion in determining when to take distributions within the 10-year time frame, if the beneficiary fails to empty the account within 10 years, the IRS imposes a 50% penalty on the amount remaining in the account.

There are, of course, a number of indirect consequences that apply even if the beneficiary complies with the 10-year distribution rule. Every distribution will increase the beneficiary’s taxable income for the year.

That creates the possibility that the beneficiary could jump into a higher tax bracket — which would apply to all income across the board.