From Stretch to Compressed: How the 10-Year Rule Is Transforming Inherited IRA Planning
Introduction: The SECURE Act 2.0 and Inherited IRAs
The SECURE Act 2.0 legislation introduced significant changes to the required minimum distribution (RMD) rules for Inherited IRA accounts, particularly the 10-year distribution rule. As a financial planner, I've observed that these evolving regulations have been challenging for both professionals and clients to navigate.
While the impact of these inherited IRA rules is extensive, today we'll focus on one key aspect: the requirement for many beneficiaries of Traditional and Roth IRAs to distribute the inherited funds within 10 years. This article aims to provide insights into how I, as a financial planner, approach this forced distribution period and explore potential financial planning opportunities that arise from this new legislation.
The End of the "Stretch IRA"
With the passing of SECURE Act 2.0, Congress eliminated a distribution strategy known as the "Stretch IRA." Previously, most beneficiaries could take RMDs based on their own life expectancy, rather than that of the original IRA owner. This allowed for smaller distributions over a much longer period, often spanning multiple decades. The new 10-year distribution rule accelerates federal tax income, (conveniently?) making budget proposals look better in the short term.
In my decade of experience helping retirees, I would rank this change among the top three that have had the biggest impact on retirement planning. It introduces a host of planning complexities by compressing the distribution period into just 10 years. To illustrate these challenges, let's examine a practical example:
Case Study: John's Inherited IRA
John is a 60-year-old married business owner. His father passed away many years ago, and recently, John's mother died at age 90 in 2024. As an only child, John is inheriting a $400,000 Traditional IRA from his mom. John's business is thriving, with his income averaging around $600,000 per year, placing him in the 35% Federal tax bracket.
While this inheritance may not make or break John's retirement, it demonstrates the significant difference between the old rules and the new 10-year forced distribution strategy.
Under the SECURE Act 2.0 rules, John is considered a non-eligible designated beneficiary. He'll need to open an Inherited IRA in his name and transfer the funds from his mother's account. Because his mother was already taking RMDs, John will be required to continue taking RMDs each year while ensuring the account is fully distributed (and federally taxed) by the end of the 10th year. If John continues working, he'll pay a substantial amount (around 35%) in federal taxes over the next decade. Under the old rules, he could have taken minimum distributions over multiple decades and potentially left some for his children to inherit. Now, he's forced to distribute during the peak earning years of his career (ages 60-70).
Roth IRA Inheritance: A Different Scenario
It's important to note how inheriting a Roth IRA differs in this scenario. If John had inherited an additional $400,000 Roth IRA, he would still need to distribute an RMD each year based on his mother's life expectancy and fully distribute by the end of the 10th year. However, these distributions would not be federally taxable. While the Roth IRA is still affected by SECURE Act 2.0 through a shortened tax-free growth period, the distributions themselves remain tax-free.
Challenging Traditional Tax Planning Approaches
Now, let's address how the 10-year rule can challenge our typical approach to tax planning. Often, when working with clients, the goal is to minimize taxes in any given year. Financial planners tend to have a more forward-looking approach, seeking opportunities to minimize taxes over a lifetime rather than year by year.
In John's case, let's assume he has an aversion to paying taxes. Upon inheriting the Traditional IRA in year one, he might fall into a common trap by asking, "What is the minimum amount I have to distribute?" If he continues taking only the minimum amount each year, he's effectively creating a tax spike in year 10 when he must withdraw everything that's left. For instance, if John takes out about $75,000 over 9 years and the IRA grows back to $400,000, he'd have to take an additional $400,000 of taxable income in year 10. This could push him into an even higher tax bracket (37% or higher, depending on future tax rates), potentially resulting in more taxes paid overall.
Strategic Planning for the 10-Year Distribution Period
I encourage my clients to consider the entire 10-year timeline and help me formulate educated financial planning projections for the decade ahead. In John's case, we might ask: Does he expect all of the upcoming 10 years to be financially similar? Could he envision making a significant business purchase, creating a tax deduction via depreciation, or experiencing business losses that could create a dip in his income? Could this inheritance actually stimulate such a decision? As a financial planner, my goal is to smooth out distributions from the $400,000 Traditional IRA to avoid pushing John into a higher tax bracket if possible, and potentially even reduce his overall federal tax burden by coordinating with other ongoing financial decisions.
Legacy Planning and Generational Wealth Transfer
Finally, let's consider how John's children and legacy/estate planning might come into play. Just as John inherited IRA funds from his mother at a financially inopportune time (during his peak earnings years), he should consider what assets would be best for his spouse to inherit, and subsequently, his children.
We're no longer just talking about the $400,000 John inherited from his mother. Let's consider the planning opportunities if John and his wife's personal assets are currently worth $3,000,000, and after a long, full retirement, they're left with $1,000,000 in retirement assets ($500,000 in a Traditional IRA and $500,000 in a Roth IRA). What if one of John's children is a physician in the top tax bracket (37%), while the other child is married with a household income in the 12% tax bracket? It's a difficult decision for parents, but from a purely financial perspective, having the physician child inherit the Traditional IRA and pay 37% each year might not be the optimal strategy. Would it be better to leave the physician child a larger portion of the Roth IRA and the lower-income child a larger chunk of the Traditional IRA? While it may be challenging to plan for this scenario in your 60s and 70s, the decision may become clearer as your spouse's age advances.
The key takeaway is that your children may inherit assets during their peak earning years, and determining whether inheriting a Roth IRA or a Traditional IRA is better isn't always straightforward. I also encourage retirees to consider Roth conversions earlier in retirement, especially if their income drops, to prepare for the possibility of one spouse dying early. Once you die, a surviving spouse who doesn't remarry falls into the higher tax bracket for individual filers, further complicating the tax implications of inherited retirement accounts.
Conclusion
Keeping up with the ever-evolving RMD rules from Washington has been challenging, even for someone like me who specializes in this field. For those who don't work in financial planning, these complex regulations often fly under the radar until crucial planning opportunities have passed. Understanding and properly managing RMDs remains a critical component of comprehensive retirement planning, especially as these rules continue to evolve.
Looking ahead, it's worth noting that the Tax Cuts and Jobs Act of 2017 is set to expire at the end of 2025. While the potential extension of these tax cuts may depend on future political outcomes, the uncertainty surrounding their expiration adds another layer of complexity to long-term retirement planning. As with all tax legislation, we'll continue to monitor these developments and adjust strategies accordingly.