It’s been a half-decade since the SECURE Act 1.0 of 2019 introduced the “10-year rule,” which eliminated stretch provisions for many beneficiaries of inherited retirement accounts, including IRAs and 401(k)s. But it wasn’t until this past July that the IRS made it clear how it expects the rule to be implemented.
Originally slated to be enforced a few years ago, the 10-year rule requires most non-spouse beneficiaries to withdraw all funds from inherited retirement accounts by the end of the tenth year after the death of the account owner. But the IRS delayed enforcement of the rule, which was then modified under the SECURE 2.0 of 2022. Confusion persisted. As a result, the IRS announced that it would not penalize beneficiaries who failed to take required minimum distributions (RMDs) for the years 2021 through 2024.
With the rule ironed out, advisors can now roll up their sleeves and make sure clients plan accordingly.
In fact, financial advisors can face a multitude of scenarios when assisting clients who are either inheriting an IRA or who are planning to bequeath one to their heirs, said Jeffrey Levine, a well-known financial planner and speaker for Kitces.com, during a recent webinar. He is also professor of planning and practice at The American College of Financial Services, which sponsored the webinar, and chief planning officer at Buckingham Wealth Partners.
The webinar examined the 10-year rule and reviewed strategies advisor could consider based on different scenarios.
Because the 10-year rule has “substantially compressed” the timeframe for distributions, beneficiaries could pay higher taxes on those funds than previously.
“I still run across a lot of clients and a lot of advisors who haven’t spent the time that’s really necessary in order to truly understand how these rules and changes will impact them — and what they can potentially do about it to minimize tax for their heirs.”
— Jeffrey Levine, The American College of Financial Services
“I still run across a lot of clients and a lot of advisors who haven’t spent the time that’s really necessary in order to truly understand how these rules and changes will impact them — and what they can potentially do about it to minimize tax for their heirs,” Levine said.
Delving Into the Details
Levine explained that the 10-year rule took the previously designated beneficiaries and split those heirs into two subgroups: eligible designated beneficiaries and non-eligible designated beneficiaries. The webinar focused on the non-eligible beneficiaries, which was a group that was further divided into subgroups.
“The SECURE Act didn’t get rid of the designated beneficiary category; it merely split it into two now,” he said.
The proposed regulations that were released in February 2022 and the final regulations that were released earlier this year even further split that group — the group of non-eligible designated beneficiaries — into two more groups of its own, Levine added.
These subgroups include individuals subject to the 10-year rule who inherited from someone who died prior to having to take RMDs, and individuals subject to the 10-year rule who inherited from someone who died on or after their start date for RMDs.
During the interactive session, Levine responded to some questions, such as “When does the 10-year rule or period begin? Is it based on the year of death, which may be a very short year, if death is later in the year, or is it based on the following year being year one?”
Levine said “The answer is year 1 of the 10-year rule is the year after the year of death.” So, if you have a client who dies January 1 of the year, “you basically have 11 years. By contrast, if someone dies on Dec. 31, they still have the full 10 years after that. Year 1 is January 1 of the year after the year the client dies.”
Two Types of Clients
There are two different sets of clients — “two different fact patterns, if you will,” he said.
One client may be the beneficiary, prompting what he called “crisis planning.”
“They’re coming into your office after the death has occurred, saying, ‘Hey, I just inherited this nice account, but I know that as I take money out, I’m going to be hit with taxes. How do I make that as low as possible for me and my family?”
Levine said the other type of client would involve proactive planning.
“Now your client is not the beneficiary, but your client is the owner, who’s still alive, who’s looking to do whatever they can on behalf of those future heirs. What can they do proactively?”
Myriad Tax Scenarios
Levine painted different scenarios that might apply to both kinds of clients.
A beneficiary might just do nothing and take no distributions through year 9 — or “kick the can down the road,” he said. That’s not a very likely option for most clients, other than those who inherited a Roth IRA or a small benefit, he added.
Another option is to spread the RMDs out as long as possible. And finally, to make what Levine called “strategic” disbursements.
“There are any number of reasons you might want to strategically time distributions,” he said.
For example, “what if you had a client who inherited today, their child was going to college, they were applying for student aid for the next three years, and after that, their youngest would be graduated and it would no longer impact their student aid,” Levine said. “Well, you might want to do nothing from the inherited IRA for three years and then spread it out over seven. There are all of these different scenarios that we want to take into consideration.”
Making a Bequest
For current retirement-account owners, Levine said, it’s very important to have family conversations about inheritance — and to involve the financial planner.
To mitigate a future tax burden, an account should consider the effects on their potential heirs. for example, a grandparent might think it’s a good idea to leave the account to their grown children. But those “kids” have kids of their own, and they’ve gone through college, and “maybe now they’ve graduated, and they’ve got student debt,” Levine said.
Parents may want to help their recent grads pay down that student debt — as parents with the means often do. “Well, if we’re going to that, why not name the grandkids directly on the beneficiary form,” Levine asked, provided they’re old enough (and that they are not subject to other taxes).
“We’re now spreading income out over more tax returns. Sometimes you can just leave it to those individuals directly over more beneficiary forms,” he said.
Adjust the Tax Burden
Levine painted another scenario of a parent who will bequeath to two adult children — for example, one a neurosurgeon, one a social worker, he said. Both are equally loved and respected by the parent, but they have very different income levels.
“So maybe in this situation, you could leave much more of the Roth account to the higher-income beneficiary or much more of the pre-tax account to the beneficiary in a lower tax-rate scenario, and that could allow you to have more net after-tax dollars to split among both of them,” Levine said.
And he urged advisors to keep in mind that there is always another “beneficiary” lurking in the background of pre-tax accounts: the IRS.
Have a Talk First
An open family discussion can have many benefits, Levine said.
“I love this because it’s such an effective tool. If you want to avoid family fighting, you’ve got to have meetings beforehand,” he said, again going back to his theoretical example.
“Otherwise, you end up with two miserable beneficiaries: One who goes, ‘I can’t believe it, Mom loved you more. She left you the account with more money.’ And the other one who goes, ‘I can’t believe it, Mom loved you more. She left you the account where there’s no taxes,’ and everyone is miserable.”
Levine suggested setting up a group call or visit with the advisor.
He suggested another possible scenario of that situation: “You get on the phone with a client in the office, you call the kids. You say, ‘Hey, I just wanted you to know I’m sitting here with Mom, and we’re talking about her retirement accounts, and how one day when she’s gone, hopefully many years in the future, they’ll be left to you and your heirs, and so we think we’ve come up with a way to actually get you and your sibling both more money on an after-tax basis when Mom is no longer here.’”
Levine said you can invite the beneficiaries to the office, too, saying, “We could explain this idea and how we can help both you and your brother or sister have more money after tax.”
“Who’s going to say no, right? And by the way, what a great introduction to those beneficiaries, so that hopefully you have a better chance of keeping them as clients,” Levine said.
College Launches New Program
During the webinar, the American College of Financial Services noted enrollment is open for its Tax Planning Certified Professional Program, the first designation curriculum dedicated to tax-informed planning for financial professionals, the college said.
Its goal is to equip financial advisors, tax professionals and CPAs with the tools to implement tax-efficient planning strategies for individuals and business owners, the college said. Access to the first course begins on Jan. 6.
Patricia McDaniel is a New Jersey-based journalist and can be reached at pmcd5353@gmail.com.
