Revisiting the RMD – Part Two: Spousal and Non-Spousal Beneficiaries

There is so much to say about required minimum distributions (RMDs), I decided to split the content into two separate posts. Last month’s post covered how RMDs are calculated as well as the rules governing these distributions.  This month’s post will cover the latest rules governing RMDs for both spousal and non-spousal beneficiaries.

Spousal Beneficiaries

If one spouse passes away and leaves their widow(er) as their IRA beneficiary, that surviving spouse has three options.  Naturally, each of these options has very different tax consequences.

1. Cash out the account and take the money

2. Transfer the IRA assets into their own IRA account

3. Transfer the IRA assets into an inherited IRA account

Here is a breakdown of the three options.

Option 1 (Cash out the account and take the money)

Withdrawing all or a portion of the money is a taxable event, and the amount received will be taxed as ordinary income. The 10% early withdrawal penalty for an individual under age 59 ½ is waived with this option.

Option 2 (Transfer the IRA assets into their own IRA account)

A person who chooses to take possession of the account and treat it as their own can delay RMDs until they are age 72, even if their spouse was already taking RMDs at the time of death. (The RMD age of 72 was designated by the SECURE Act of 2019. Previously, it was 70 ½.) The additional tax deferral can make this option appealing for surviving spouses who are younger than the deceased. The surviving spouse also has the ability to appoint their own beneficiaries to inherit the account when they pass away. If the surviving spouse is over age 59 ½ they can take withdrawals from the IRA penalty free. A surviving spouse under age 59 ½ would be subject to early withdrawal penalties if money is taken from the account.

If the inherited IRA has a large balance, combining it with another IRA may result in more sizable RMDs than originally anticipated, pushing the recipient into a higher tax bracket when they reach the age at which the RMDs are required. This is where a well-planned Roth IRA conversion strategy can be beneficial. A Roth conversion strategy can help reduce the balance of the Traditional IRA to a level where the RMDs create less tax disruption.

Option 3 (Transfer the IRA assets into an inherited IRA account)

The third option is to transfer the assets into an inherited IRA.  When the surviving spouse is older than the deceased, this option is beneficial because the RMDs can be minimized.  In addition, this option may be beneficial if the surviving spouse is younger than 59 ½ and would like access to the money, as early withdrawal penalties would not apply under this circumstance.

If the deceased had not yet started RMDs at the time of their death, RMDs can be delayed until the deceased would have been 72. Then, distributions will be based upon the single lifetime table. If the deceased had already begun RMD withdrawals, RMDs must continue and can be based on the longer withdrawal timeframe between either the deceased spouse’s previous withdrawal schedule or the single lifetime table.

Non-Spousal Beneficiaries

The SECURE Act of 2019 made several changes to rules governing non-spousal IRA beneficiary withdrawals. It used to be the case that a “stretch IRA” was a powerful tool for deferring taxes and passing wealth to the next generation. However, based on changes made by the SECURE Act, inherited IRA distributions can no longer be stretched over the beneficiary’s lifetime, unless the beneficiary is an “eligible designation beneficiary,” which includes only spouses, minor children (additional rules apply), beneficiaries who are less than 10 years younger than the deceased, and those who are disabled. All beneficiaries who do not fit these categories must now empty the account within 10 years if the deceased IRA account owner passed away on or after January 1, 2020. The money does not have to be taken in even installments or according to any type of schedule. The only rule is that the account balance must be $0 by the end of the 10th calendar year following the original account owner’s death. The good news is that while these withdrawals are taxed as ordinary income, early withdrawal penalties do not apply if the beneficiary is younger than age 59 ½. If the IRA balance is large, this is also a place where a Roth conversion strategy may be beneficial.

Rules regarding Trusteed IRAs as well as discretionary and conduit trusts are also affected if the beneficiary of the trust is not an “eligible designation beneficiary.” For those who have incorporated these vehicles into their estate planning, trust beneficiaries may need to be changed, or the estate planning strategy may need to be reconfigured to incorporate different types of trusts.

Conclusion

With the recent shift in inherited IRA rules, it may be time to revisit your wealth transfer and future tax planning strategies. IRA balances that double due to the unexpected death of a spouse, and accelerated payout timelines for non-spousal beneficiaries, can increase tax liabilities and require advanced planning. If it has been a while since we have reviewed these items, it might make sense to revisit your RMDs and their future impact on your family’s financial picture.