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The SECURE Act Has Changed How a Large IRA Should Be Dealt With in an Estate Plan

July 15, 2021

When the Setting Every Community Up for Retirement Enhancement (“SECURE”) Act became federal law on December 20, 2019, it significantly changed the rules about when money has to be withdrawn (and thereby taxed) from inherited IRAs and defined contribution plans such as 401(k)s and 403(b)s. For deaths that occur after 2019, the SECURE Act requires the entire balance of an inherited IRA to be distributed or withdrawn within 10 years of the death of the original IRA owner.

The exceptions to this 10-year rule are when the beneficiary is a surviving spouse, a disabled or chronically ill person (as defined by the IRS), a person not more than ten years younger than the IRA owner, or a child who hasn’t reached the age of majority. A minor child who later reaches the age of majority then becomes subject to the 10-year rule.

The IRA can be partially or fully withdrawn at any time and in any installments desired by the beneficiary during that 10-year period after the original IRA holder’s death. The IRS has recently published its interpretation of the new rules in Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs), and decided that the IRA beneficiary must also make required minimum distributions during that 10-year period (unless the remaining amount in the IRA is withdrawn before the 10 years are up). There is no leeway in the SECURE Act for most beneficiaries, and the penalty for not complying with the withdrawal requirements is a punishing 50% federal excise tax, which is much higher than the highest federal income tax bracket.

Before this change in the federal income tax laws, the normal thought process of many financial planners was for an original IRA holder to take out the bare minimum from the IRA, let the IRA grow and stretch out the family’s withdrawal process for as long as possible, sometimes for generations. Now that the beneficiaries in the next generation are required to drain the IRA within 10 years, that type of thinking almost needs to get reversed. Where the beneficiaries will be adding their IRA withdrawals on top of their other taxable income, and that tax rate can be higher than what the original IRA holder has been paying, it may make sense in many cases for the original IRA holder to be withdrawing much more from the IRA annually, perhaps to the top of the current 24% federal income tax bracket when considering the IRA holder’s other income.

During the estate planning process, most parents want to treat their children equally, even where one child is much more financially successful than another child, so this tax law change needs to be factored into the estate plan. Treating the children equally does not necessarily mean leaving each of them with an equal share of each asset; is an estate plan really equal if the wealthier child would be saddled with greater income taxes as an equal beneficiary of a large IRA? To truly make the inheritance roughly “equal,” it may make sense in some families to leave a larger percentage of a large IRA to the child in the lower income tax bracket, and to leave more of the other assets to the wealthier child.

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