In our work with families that span generations, we plan for IRAs to be passed down to children or grandchildren so that they can continue to harness the power of tax deferral for up to another 50 years. Think of how powerful that is. Being able to stretch IRA distributions over a beneficiary’s entire lifetime led to essentially an additional lifetime of tax free growth as long as there was no immediate need for the inheritance.
In December 2019, the SECURE Act was passed into law which made some important changes to our current tax legislation, one being the introduction of the 10 Year Rule for inherited IRAs. The 10 Year Rule mandates that a non-spousal beneficiary must distribute the entire inherited IRA by the end of the 10th year after the inheritance.
There are not any requirements for when you distribute the income within those 10 years, and this opens the door for some planning opportunities in certain circumstances. The main goal of this planning strategy is to recognize income in years where you can fill up your lower tax brackets with the income. If your income will be unchanged for the entire 10 years, just taking even distributions of 1/10th of the account would likely make the most sense.
However, if you know that your income will likely have some large spikes up and down over the next 10 years, there are certain years that will be better to recognize more income. Like anything with a 10 year time horizon, you don’t know exactly what your income will be each of the next 10 years, but there are some situations where you can make some really solid predictions.
Perhaps the easiest situation to understand was if you received the inheritance shortly before you planned to retire. If you received the inheritance at age 58 and you were planning to retire at age 65, your income will drop drastically when you retire and you could then distribute the account over those next few years filling up the lower tax brackets instead of recognizing that income on top of your regular income prior to retirement.
Or you could have a situation where you are coming up on the prime of your career in the next 5 or so years and are expecting a promotion with a large pay increase. In a situation like that it would make sense to take more out in your first few years before you potentially jump up to a higher tax bracket.
Another situation would be that you are planning to make a career change or start a new business and you expect to have one or two years with little to no income over the next 10 years, in this situation you would distribute as much as you can to fill up lower tax brackets in those years with minimal income.
Regardless, if you or anyone that you know have inherited an IRA over the past 6 months, or receive one in the future, it is crucial to keep these changes in mind and we invite you to please contact us if you would like our help in formulating a strategy for your distributions. Situations like this are easy to ignore and maybe you plan to focus on it at another time, but these types of strategies are best to implement as soon as possible so that you don’t have to play catch up later down the line. If you do not make any distributions over the 10 years after you inherit the account, you will be forced to distribute the entire account at the end of that 10th year. Depending on the size of the inherited IRA, this could leave you with a large and unexpected tax burden.