Avoiding a big tax bill on inherited IRAs

Americans hold an estimated $18 trillion in IRAs and $13 trillion in defined contribution plans, and some of these funds will ultimately pass to the account owner’s designated beneficiaries upon death. Financial advisers can help clients lessen the tax bill from the transfer of these retirement accounts.

The rules governing inherited retirement accounts have changed in recent years. “It was so much easier when you could inherit an IRA and stretch out [the distributions] over your lifetime,” said Erin Itkoe, CPA/PFS, CFP, president and wealth adviser at Luminescent Wealth Management in Scottsdale, Ariz., referring to traditional retirement accounts as opposed to Roths. A beneficiary could “stretch” the period for required minimum distributions (RMDs) by taking small amounts over their lifetime, which might be another 40, 50, or 60 years.

But now, most nonspouse beneficiaries must draw down inherited retirement account funds within 10 years, due to a change made in the SECURE Act (Setting Every Community Up for Retirement Enhancement Act of 2019 (Division O of the Further Consolidated Appropriations Act, 2020, P.L. 116-94)). More specifically, lifetime stretching can only be done by spouses and certain other eligible beneficiaries, including disabled individuals and individuals who are not more than 10 years younger than the IRA owner.

Other beneficiaries, most importantly, the adult children of the account owner, must completely empty the inherited retirement account within 10 years — which means they cannot benefit from its tax advantages for as long as they formerly could have.

This article discusses strategies for lessening the impact of the 10-year drawdown rule, focusing on traditional retirement accounts.

WHY THE 10-YEAR RULE MATTERS

Unlike taxable brokerage accounts, said Marianela Collado, CPA/PFS, CFP, senior wealth adviser and shareholder at Tobias Financial Advisors in Plantation, Fla., “retirement accounts never get a step-up in basis, so at some point, whether it is in your lifetime or your children’s lifetime, someone has to pay the piper,” i.e., the tax.

Consequently, for beneficiaries subject to the 10-year drawdown rule, “there’s a lot of planning that has to happen in terms of how and when you take out [the funds],” Itkoe said, because otherwise there could be “a pretty big tax hit.”

SMART WITHDRAWAL STRATEGIES FOR HEIRS

“What I’ve been doing with my clients,” Itkoe said, “is having a conversation at the beginning when we start planning for this 10-year rule and saying, ‘You know this is going to be an annual conversation.'”

Beneficiaries are usually better off spreading withdrawals over the 10-year period to avoid a big tax hit at the end, Itkoe said. One approach: take one-tenth of the IRA in Year 1, one-ninth in Year 2, and so on, with the remaining amount in the IRA withdrawn in the 10th year. But the client’s specific tax situation for each year needs to be considered.

“The biggest thing is you’ve got to plan around your tax brackets,” she said, because, in a given year, the opportunity could exist to take a larger distribution. “You can’t set a strategy in Year 1 and just stick with it for the 10 years.”

Notably, Itkoe suggests spacing out the distributions even if the beneficiary has no obligation to take RMDs during Years 1 through 9 but just needs to empty the account within 10 years — which is the case if the original account owner died before beginning RMDs. In contrast, if the original owner died after beginning RMDs, the beneficiary must take RMDs during Years 1 through 9 (and empty the account in Year 10).

Spreading withdrawals over the 10-year period is often best, even if RMDs in the first nine years are not required, “because you don’t want to get hit with a big tax bill in Year 10,” Itkoe said.

Itkoe also recommends withholding taxes on the withdrawals so clients don’t have to worry about making estimated tax payments throughout the year.

PLANNING MOVES FOR ACCOUNT OWNERS

Planning isn’t just for heirs. Account owners can also take steps now to help their beneficiaries later. One potential strategy they can consider when beneficiaries, such as their adult children, will be subject to the 10-year drawdown rule is doing a Roth conversion.

“We model that out,” Collado said, noting the high initial hurdle of immediate taxation on the rollover amount. “We show whether there’s a benefit from the Roth conversion over the client’s lifetime, but where rubber meets the road here, is there a benefit over the lifetime of next gen?”

Although most nonspouse beneficiaries of Roth accounts must empty out the inherited account within 10 years, the beneficiary generally will not need to pay tax on the distributions — and they can wait until Year 10 to withdraw the money because there are no annual RMDs — which allows the full amount to grow tax-free.

Another potential strategy for account owners in response to the 10-year drawdown rule, besides a Roth conversion, is making a charitable gift. More clients have been leaving retirement account funds to charity because of this 10-year limit. “If they’re charitably inclined and were going to leave something to charity anyway, now the IRA is an even better asset because the kids or grandkids don’t get that [lifetime stretch they used to receive],” Itkoe said. In other words, the client could consider leaving their children or grandchildren a different asset instead.

One sophisticated strategy to create a lifetime stretch that certain clients may wish to consider is to leave the retirement account to a charitable remainder trust (CRT). Using a CRT, a chosen beneficiary (which could be a child or grandchild) can receive annual payments for life or a set term of up to 20 years, with the remaining funds going to charity after the beneficiary’s death or the end of the term.

In effect, “you can take an IRA that has a 10-year payout and convert it into a lifetime payout,” Collado said. “But again, this strategy only works if you’re also willing to give to charity.” She noted that a high-interest-rate environment is optimal for CRTs.

While more exotic strategies exist, the ones discussed above are most commonly used for lessening the impact of the 10-year drawdown rule.

ADDITIONAL TIPS

Even clients with modest retirement accounts can benefit from this type of planning because even relatively small distributions from an inherited account could bump their beneficiaries into a higher tax bracket, Collado and Itkoe said.

The 10-year drawdown rule generally operates in a similar way both for IRAs and defined contribution accounts such as 401(k)s; however, defined contribution plans sometimes have their own special rules and might, for instance, require a faster inherited-account payout.

The bottom line: Your advice as a CPA about distribution timing, Roth conversions, charitable strategies, or other matters could significantly reduce clients’ tax burdens from inherited retirement accounts.

Finally, be sure to remind clients that retirement accounts are inherited by the individuals designated as beneficiaries in the account itself, and this can override what a will says, so it is important to keep retirement account beneficiary designations up to date.

For more information, AICPA members can consult The Adviser’s Guide to Financial and Estate Planning, Vol. 1.

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About the author

Dave Strausfeld, J.D., is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.

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