Beneficiary selection is one of the key elements of estate planning: without the right name on the right dotted line, assets can end up in the hands of those the deceased did not intend to receive. All assets need the correct beneficiary(ies), usually dictated by a will.

A person who inherits the assets of the original owner’s Individual Retirement Account (IRA) is called a first-generation beneficiary or original beneficiary. If the first generation beneficiary subsequently dies, their designated beneficiary is the second generation beneficiary or successor beneficiary. Whether the original beneficiary of an IRA can name a successor beneficiary is determined by the provisions of the IRA plan document.

Sometimes overlooked by the non-spouse beneficiary of an inherited IRA is the task of naming the beneficiaries themselves. In fact, IRA holders couldn’t bequeath this asset to beneficiaries until 20 years ago, when the IRS gave IRAs the green light to potentially go through multiple “generations” of holders, while increasing deferred tax.

Naming IRA Beneficiaries

After inheriting an IRA, a beneficiary’s designation of their own beneficiary(ies) is just as important for non-spouses (and spouses) as it is for the original account owner. Also, as with the original IRA owner, beneficiary designations on the IRA form replace the instructions in a will: review and, if necessary, update the list of new beneficiaries annually or at least every a few years.

An inherited IRA must also be renamed to distinguish it as an inherited IRA and to identify the original account holder and the inheriting beneficiary. For example, “(name of original owner of IRA) died (date of death of original owner) to (name of beneficiary)”. Another example might be “(deceased’s name and date of death) IRA inherited for the benefit of (FBO) (beneficiary’s name)”.

Legacy IRAs: old rules

Prior to the SECURE Act, non-spouse beneficiaries of IRAs had the ability to “stretch” IRA distributions over multiple generations. It was an efficient method of wealth transfer that minimized taxes. Inherited IRAs had required minimum distributions (RMDs) that had to be withdrawn each year, based on the life expectancy of the person who inherited the IRA. This was beneficial for younger beneficiaries who had long remaining life expectancies, as they could “lengthen” the length of time they were to receive IRA distributions while allowing the rest to grow tax-free.

A beneficiary can always take more than the RMD. However, it would be foolish from a tax planning perspective to take more than the required minimum during the beneficiary’s best earning years when they were in a high tax bracket. “This could result in a substantial increase in their total taxable income and could push them into the highest tax brackets,” says Bruce Primeau, CPA, president of Summit Wealth Advocates, Prior Lake, Minn.

If an original beneficiary died before the entire inherited IRA was exhausted, the successor beneficiary was able to “step into the shoes” of the original beneficiary. They could continue to take the RMD every year depending on the remaining life expectancy of the original beneficiary. Thanks to this method, the “stretch” could continue for generations.

Under previous law, Primeau notes, the person who inherits this IRA must begin receiving the required minimum distributions by December 31 of the year following the year in which the original owner died. “Another piece of advice for those inheriting those IRA dollars, assuming the inheritance is substantial: Consider getting a tax projection right away and, if possible, raise the contribution rate to their 401(k), 403(b). ) or another retirement plan, at most so they can shelter some of those RMD dollars from taxes.

Amendments to the SECURE law: non-spouse beneficiaries and successor beneficiaries

The SECURE Act passed as part of two year-end spending bills and signed into law on December 20, 2019, significantly changed the rules for inherited IRAs for an IRA owner who died on January 1, 2020 or later. A major change ended the practice of extended IRAs, in which required minimum distributions could be extended throughout the life of a non-spouse beneficiary and could be passed on to a second-generation beneficiary.

Under the new legislation, beneficiaries fall into one of three categories: Eligible Designated Beneficiaries (EDBs), Designated Beneficiaries (DBs) and those who do not qualify as Designated Beneficiaries. Eligible Designated Beneficiaries (EDBs) are anyone designated by the IRA who is:

1. Joint
2. Minor children
3. A person with a chronic illness
4. A disabled person
5. Someone less than 10 years younger than the IRA owner

Non-person entities such as trusts, charities, and estates belong to the third category, not classified as named beneficiaries. Most non-spouse beneficiaries will therefore fall into the second category of designated beneficiaries. This includes most adult children.

10 year rule

People in the second category, including most non-spouse beneficiaries, must withdraw all inherited IRA funds within 10 years of the death of the original account holder. Additionally, second-generation beneficiaries who inherit in 2020 or later are no longer able to “stretch” their distributions, even if the original IRA owner died before 2020. They will instead be subject to payout rules. ten years old.

Non-spouse beneficiaries cannot transfer the inherited IRA into their own IRA or contribute to an inherited IRA. Beneficiaries pay no early withdrawal penalties on distributions (even if the beneficiaries are under age 59.5), but they do pay income tax on withdrawals from inherited traditional IRAs. Contribution withdrawals from inherited Roth IRAs are tax-free at all times. Earnings from an inherited Roth IRA are tax-exempt as long as the account has been open for at least five years before the death of the owner.

10-year rule and RMD

The concept of required minimum distributions (RMDs) has also been removed as part of the ten-year payout rule. There is no fixed minimum distribution that a beneficiary is required to receive in a year. Yet, the entire inherited IRA balance must be exhausted by the end of the 10-year period following the death of the IRA owner. This gives the beneficiary some flexibility to accept larger distributions in years when they would be in lower tax brackets. However, it also limits the overall length of time the funds can grow tax-free and limits the ability to stretch the funds over many years or generations.

Examples of Legacy IRAs

1) Alex passed away on February 3, 2020 and named their 32-year-old grandson, Sam, as the beneficiary of the IRA. Alex is not an EDB under the SECURE Act. Therefore, Sam must withdraw the remaining funds from the IRA by December 31, 2030.

2) Liu passed away on November 30, 2019. Prior to his death, Liu named his 40-year-old niece Chen as beneficiary. Because this was before the SECURE Act was passed, Liu was using the old IRA stretching method to bring RMDs over their remaining life expectancy. Liu named an adult child, Xiao, as successor beneficiary (second generation).

If instead of dying in 2019, Liu unexpectedly dies in 2029, Chen will no longer be able to continue the stretching method. As a designated beneficiary who is not a post-SECURE Act EDB, he would be expected to withdraw the remaining funds from the IRA within 10 years, by December 31, 2039. There will be some flexibility in choosing when to take these distributions over the following 10-year period. If Chen loses his job at any time during this 10 year period and temporarily finds himself in a lower tax bracket, this would be the most ideal time to take the majority of the funds from a tax planning perspective. .

3) Sam passed away on April 6, 2020 and had named Addison as joint beneficiary of the IRA. As a beneficiary of the EDB and spouse, Addison always has the option of taking life expectancy distributions from the IRA. Addison subsequently designates their adult child, River, as successor beneficiary. If Addison subsequently dies on August 3, 2024, River will no longer be able to use the life expectancy method and must instead exhaust the remaining funds by December 31, 2034.

4) Cameron died on March 23, 2020 and named a nephew as beneficiary of the IRA. A nephew is not an EDB and therefore must use the 10-year payment rule. The nephew then designates his brother as successor beneficiary. If the nephew subsequently dies in 2023, before the IRA is exhausted, his brother will be locked into the same 10-year period that began when Cameron died and will therefore have to finish withdrawing funds from the IRA from here on December 31, 2030. .