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Join the wealth strategists of CIBC Private Wealth as they shine light on the topic of wealth planning by sharing their insights and ideas on how to use wealth in ways that are important to you—whether for your own needs, the people you hold dear or the causes that you care about.
Theresa:
Hello and welcome to another episode of Wealth Planning Illuminated. I'm your host, Theresa Marx, a Senior Wealth Strategist at CIBC Private Wealth in the us. I am joined today by my colleague Caroline McKay, also a Senior Wealth Strategist at CIBC Private Wealth. In today's episode, Caroline and I will discuss inherited IRAs After the Secure Act. In particular, we will take a look at the beneficiary classifications and the withdrawal methods that now apply under secure. Alright, with that, let's get started.
When the setting Every Community Up for Retirement Enhancement Act, or better known as the Secure Act became effective on January 1st, 2020, the rules for how inherited IRAs must be withdrawn changed significantly. The Secure Act, along with some subsequent notices and proposed regulations from treasury, have led to many questions on just how someone is supposed to withdraw an inherited IRA when they are the beneficiary of that IRA. So Caroline, I thought we could talk through the rules that apply when someone is trying to determine when they must withdraw assets from an inherited IRA. But first I do think it's important that we note that the rules we're going to talk about today really only apply to inherited IRAs where the owner died on or after January 1st, 2020. So for inherited IRAs that were in existence before that, because their owner died before January 1st, 2020, the old rules were generally the beneficiary could withdraw assets from an inherited IRA over their own life expectancy. Those rules continue to apply for those older inherited IRAs. So we're really focused today on the new, if you will, inherited IRAs for owners that died on or after January 1st, 2020. So with that little caveat, let's start with the types of beneficiaries that came up under secure because I think it's really the beneficiary type that ultimately helps us decide the distribution method. So if you could get us started with what types of beneficiaries, how do we classify a beneficiary?
Caroline:
Yes, absolutely. So as you said, how long someone has to withdraw money from an inherited IRA is going to depend on their beneficiary classification. I'm going to put out some technical terms here that the IRS has defined because that if you have ever inherited an IRA or will inherit an IRA, these terms will be used quite often. So it's important to understand the differences. So the first type of beneficiary is called an eligible designated beneficiary, and the people who fall into this category include the participant surviving spouse, so the IRA owners, surviving spouse, minor children of that account owner disabled or chronically ill individuals who have been named as a beneficiary or beneficiaries who are less than 10 years younger than the deceased account owner, which also happens to include people who are older than the account owner. So it seems fairly broad, but in most of our cases, surviving spouses, absolutely we see that very often. Outside of that though, it's less often that we might see minor children inheriting or disabled or chronically ill individuals. So eligible designated beneficiaries is sort of a limited class of people
Theresa:
And I think it's important the minor children kind of eligible designated beneficiary. We get that question a lot. I think when people sometimes think, oh, if my grandchild is a minor then I can leave it to them and that will qualify. But I think what you said was important. It's the minor child of the owner. It's not just any minor child.
Caroline:
That is absolutely right. So it is more limited than it might sound off the cuff. So any person who does not fall into this eligible designated beneficiary category is now known as something called the designated beneficiary, and that's a much larger group in terms of when we see people naming beneficiaries of their IRAs. If it's not the surviving spouse, oftentimes it might be an adult child or a grandchild, both of whom typically are going to fall into this designated beneficiary category. They're not going to be considered an eligible designated beneficiary. And then the final category is something called a non-designated beneficiary. So if you're not eligible designated beneficiary and you're not the designated beneficiary, you fall into this designated beneficiary category, which is sort of a tongue twister when you try to say it now. And that is a beneficiary who really is typically an entity and not an individual. So let's say you didn't name anybody as the beneficiary of your IRA by default, it then flows into your estate. Your estate is not a person, so thus it's considered the non-designated beneficiary. Same with a charitable organization or a non-qualifying trust. So those high level are the three types of beneficiaries that help us determine how long the beneficiary has to withdraw funds from the account.
Theresa:
So now that we know what different types of beneficiaries that there are, I think our next question really is what are the distribution methods available to different types of beneficiaries? So one of the most common ones we see is of course a spousal transfer. So can you walk us through that and the options in a spousal transfer?
Caroline:
Sure. So if someone has named their spouse as the primary beneficiary of their account or even a partial beneficiary of the account, that spouse sort of has the broadest options in terms of the distribution methods. So they are falling into this eligible designated beneficiary category, and because they're a spouse too, they are provided even more benefits as sort of this special classified person. So a surviving spouse has the option to either inherit the IRA and take distributions over the life their life expectancy, or they can actually transfer the IRA into their own personal IRA effectively combining it or treating it as their own personal IRA, which has the benefit of now required. Minimum distributions are determined based on that spouse's age. So if they're younger than the account owner, when the account owner died and maybe is not subject to A RMD yet, they could delay it. They can name their own beneficiary. So spouses really have two options. They can follow sort of an inherited IRA methodology, which requires them still to take RMDs over their life expectancy, but they don't get to name a following successor beneficiary and things like that. Or they can roll it into their own IRA and treat it as if it was always their money, which is a be that no other beneficiary has under these IRA rules.
Theresa:
And I think it's probably the most common that we see a surviving spouse doing that spousal transfer, treating it as their own, it becomes their own account. I think it's just simpler in a lot of ways, but also has the benefit, as you said, kind of spreading it out over their life expectancy and their age, really determining those RMDs.
Caroline:
Yeah, and the only time again we consider other options is when there's maybe an age disparity between the account owner who died and the spouse. There are sometimes some benefits for doing it one way versus the other, but you're absolutely right. In almost all cases we typically see the spousal transfer.
Theresa:
So you mentioned the life expectancy method. Can you walk us through what that is and into what beneficiaries that method might apply?
Caroline:
Sure. So the life expectancy method says that the beneficiary who is eligible to use this method can take distributions over their life expectancies. RMDs in that case start pretty much right away one year after the death of the account owner. And again, the only thing that has to be taken out every year is this required minimum distribution based on the age of the beneficiary in the year following the death of the account owner. That was sort of the rule under pre secure that most people know this is the life expectancy method. The big difference post secure act is that this life expectancy method is typically only available to this eligible designated beneficiary category. So it's a smaller population of people that have this option, but the life expectancy method effectively just gives the person who's inheriting it, who qualifies distribution over their life, which just allows the money oftentimes to stay in the protection of the IRA account in terms of not having to pay taxes inside the IRA for a longer period of time.
Theresa:
This is one of those methods that I think it's important to note too, that it applies not only to a traditional IRA that you're inheriting, but also to a Roth. I think we sometimes think of a Roth IRA as having this never have to take distributions, but under the life expectancy method, the Roth IRA would have to start coming out over that period. Correct.
Caroline:
That's absolutely true. So while the owner of a Roth account does not have to take RMDs under the life expectancy method, somebody who has inherited the Roth IRA would have to take RMDs over their life expectancy. That's absolutely correct.
Theresa:
So I think we've mentioned it a couple times that really one of the biggest changes with secure was this introduction of the 10 year method where we went from the stretch life expectancy method to the 10 year method. So can you walk us through the 10 year method and what that means for a beneficiary and who it might apply to?
Caroline:
Sure. So the 10 year method applies or requires that the entire IRA account be distributed by December 31st of the 10th year following the account owner's death. So the 10 year rule is okay, you only have 10 years in which to remove all of the money. And again, this rule is sort of the now default rule for everyone in that designated beneficiary category that is going to primarily if you think about if an adult child is inheriting the count or even a grandchild, because remember we talked about that minor child rule doesn't apply to grandchildren, most people outside of these eligible designated beneficiaries are going to have this 10 years. And of course, because nothing is simple with treasury and the IRF, there's sort of two aspects of the 10 year method. One piece of the 10 year method is if the account owner died before their required beginning date, which is essentially the date where they have to start taking RMDs. So currently that age is 73, right? So if the account owner and our examples for 2024 died before they turned 73 and were not taking required minimum distributions, let's say their adult child inherits the account, that child has up to 10 years to make distributions and they can take it all in year 10 or they can take it piecemeal over the 10 years. It's really up to the beneficiary how much they withdraw during that 10 year period. But it all has to come out at the end of the 10th year.
Theresa:
So they're not required to take one 10th out every year or any sort of required minimum distribution. They have the freedom to look at their own cashflow and figure out what makes the most sense as long as it comes out by that end of the 10th year.
Caroline:
That's absolutely correct. Then the second piece of this 10 year method is for rules related to if the account, sorry, the account owner died after that required beginning date. So in my example, if we're using age 73 as the starting date for when you have to take RMDs, if the account owner died after that date, then we have these proposed regulations that say that these designated beneficiaries over the 10 years that they have to withdraw the at entire account, they also have to take required minimum distributions based on their age. So it's a little bit of a confusing rule and sort of through the planning world for a loop because when we first heard the 10 year rule, we all thought, great, you have 10 years to take out the money and you take it out as you want. Then treasury came out with these proposed regulations saying Actually if you died after this required beginning date, we read the statute to say that you have to take these RMDs over the 10 year period.
The hard part right now is that these are still proposed regulations and have not been finalized and so far over the last couple of years, the IRS keeps putting out notices saying, okay, proposed regulations haven't been finalized and we're going to allow someone to avoid taking, you won't be penalized for not having taken a required minimum distribution. Those notices have gone now through 2023. We do not have anything yet in 2024 indicating whether that rule of having to take an RMD will be punted or will start applying. So if you happen to be listening and you have an inherited account of someone who died between 2020 effectively and today, you should be paying attention and working with your tax advisor or financial advisor to understand when you might have to start taking this required beginning minimum distribution.
Theresa:
So it sounds like once you know what type of beneficiary you are and if you fall within this 10 year rule, the next question is, okay, did the owner die before that required beginning date or after that required beginning date? And if it's after, it's kind of still asking yet another question is what has the IRS said or has Treasury told us more to either finalize those regulations or kind of punted it down the road again?
Caroline:
That's absolutely true. So it is very complicated. You can tell probably from just what we've talked about before. So it is important to understand what date did the person die, the account holder died, what beneficiary classification you're in, and if you're falling into this 10 year rule, you need to know again whether the person was taking RMDs or not. And if we have a Roth, there is no beginning date for a Roth because no required minimum distributions are ever required for an account holder. So if you happen to inherit a Roth IRA and you're subject to this 10 year rule, you get a little bit lucky and know that you just have 10 years to take out the money. You don't have to worry about taking potentially a required minimum distribution.
Theresa:
Okay. So one more method other than just taking the whole account and taking a lump sum distribution, but the five-year method, and this is one that was pre-secure as well for certain beneficiaries and it still applies today. So what is the five year method?
Caroline:
Yeah, so the general rule for the five-year method is if you are one of these classifications of non-designated beneficiaries, so a non-qualifying trust, an estate, a non-person is inheriting, the general rule is they have five years to take out the money from the IRA and then of course because nothing is simple, there is a caveat that again, if the account owner died after the date that they were taking required minimum distributions, there's actually a life expectancy method that's used. Again, we find that less, it's more rare that we see the five-year rule being imposed because most people have named individuals or qualifying trusts as the beneficiary of their plans. Really when you worry about this five year method or this sort of pseudo life expectancy method is if you fail to name somebody as a beneficiary is most often when it comes up.
Theresa:
But it's within a state in particular because if it's a charity, a charity really doesn't care as much about the withdraw method because they don't pay the income taxes. So I do think it happens most within a state because somebody forgets to name a beneficiary for their accounts.
Caroline:
Yeah, absolutely.
Theresa:
So just real quick, we've mentioned a couple of times RMDs and if somebody has to take an RMD and as a caveat, these are very complicated rules. There are charts and things, but can you just on it just to wrap it all together in a nice little bow, what are we looking at when we're thinking about RMDs for an inherited IRA?
Caroline:
So the way we calculate an RMD associated with an inherited account when it applies and we need to calculate it, it's based off of the account value as of December 31st of the previous calendar year. And then you divide that or yeah, it's divided into a life expectancy factor that the IRS provides and anybody who has a retirement account, they may be somewhat familiar with RMD calculations because in some ways it is very similar. The one big caveat is the life expectancy factor is different based on when you're, if you're alive versus if you're inheriting an account primarily, and there's some caveats here, but primarily when we're calculating RMDs with inherited accounts, for the most part we're using a single life expectancy table. So it's factoring just one person's life. We look at the beneficiary's age, the year following death, there's a table that gives us a life expectancy factor.
Let's say they expect based on that person's age that the person will live 30 years. So year one, your life expectancy factor is 30 every year thereafter that an RMD is being calculated. We take that 30 years and we just subtract one. So every year it's one less. That's a little bit different than when you're alive and you're having your RMD calculated. That type of RMD when you're alive is typically based off of a different life expectancy table that usually anticipates that there's a second person, like a spouse involved. So the life expectancies tend to be greater. I mentioned that only because Theresa, you and I have both been part of many questions related to people looking at life expectancy factors on an inherited account and then looking at their own IRA and saying, why are they so different? And that explains it because we mentioned earlier that surviving spouses sort of are the special classification. The life expectancy factors for spouses are a little bit different than what I just mentioned and tend to be, again, a little bit better in terms of having longer life expectancies. But that's sort of the highest level. I can explain it with that going too deep into the weeds.
Theresa:
But so if I am an owner of my own IRA taking RMDs and I'm a beneficiary of an inherited IRA taking RMDs, I shouldn't be surprised if I see that my life expectancy is different between those two accounts because it's a different table. It's a different
Caroline:
Approach. Exactly right.
Theresa:
Alright, so thank you so much for walking us through these. You said there are so many nuances and we both have been part of many conversations with clients that there's just one little difference and it changes the whole analysis. So I do think it's really important, everybody listening to this, if you have an inherited IRA in particular, look at your particular circumstances, talk to your financial advisor. As soon as you hear that you've inherited an IRA, start working with your advisors to really make sure you know what method you fall under, what type of beneficiary you are to make sure you're following the rules that apply to your particular inherited IRA that you are as a beneficiary. So we hope this has been helpful as we navigate these post secure rules. Thank you so much.
Thank you for joining us for this episode of Wealth Planning Illuminated. We hope you found this topic interesting and that you will continue to explore the variety of wealth planning topics available to you on this channel. Thank you and have a great day.
Disclosure:
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