Skeels Cygan: Important beneficiary rules for IRAs

Last month, I wrote about the tax-free benefits of Roth IRAs. A few days later, I received an email from a reader that led to this month’s topic. He asked if his two daughters and two grandsons — who are the beneficiaries of his traditional IRA — will be allowed to convert his traditional IRA to a Roth IRA after he dies. I’ve written several articles about the advantages of Roth IRAs, but I have never discussed the beneficiary rules, which changed with the Secure Act of 2019.

The rules vary significantly, depending on the type of beneficiary. Today’s article breaks it down for non-spouse beneficiaries (such as children, grandchildren, other relatives or friends), spouses (and other special categories listed below) and charities.

Non-spouse beneficiaries

Let’s start with a refresher on traditional IRAs. The money in traditional IRAs is tax-deferred, meaning it has never been taxed. When withdrawals are taken (after age 59½ to avoid penalties), the amount withdrawn is fully taxable. Required minimum distributions (RMDs) are required to begin at age 73 for persons born before 1960, and age 75 for those born in 1960 or later.

Before 2019, traditional IRAs had a stretch provision, which allowed beneficiaries to withdraw money each year based on their age. If a 25-year-old inherited a traditional IRA, the required annual withdrawals were very small, thereby triggering minimal taxes and leaving the majority of the money in the IRA to continue growing tax-deferred for many years. The stretch IRA was a valuable tool for passing money down to younger generations, and many investors saved diligently in their traditional IRA and 401(k), knowing they could pass the accounts down to children or grandchildren.

The Secure Act eliminated the stretch IRA and replaced it with a 10-year rule for non-spouse beneficiaries. All the money in an inherited traditional IRA must now be withdrawn within 10 years after the original owner’s year of death, and the full amount is taxable to the beneficiary. (If an IRA owner died in 2021, the 10-year rule covers 2022-2031). Also, if the original owner of the IRA was old enough to be taking RMDs, then the beneficiary must also take RMDs each year during the 10 years. The new rule is far less favorable for passing money down to younger generations than the old stretch IRA rules. Clearly, the 10-year rule causes non-spouse beneficiaries of traditional IRAs to pay the tax much sooner than under the old stretch rules.

Let’s assume you die at age 72 (before starting RMDs) and you leave your traditional IRA to your son, who is 42. He is not required to take RMDs, but he must withdraw the full amount of the inherited IRA within 10 years, and the amount withdrawn each year will be added to his regular income. He may be in his prime-earning years, so these taxable withdrawals can place him in a very high tax bracket. He is not required to take withdrawals every year, but leaving the full amount to be withdrawn near the end of the 10 years could lead to excessive taxes.

Furthermore, a non-spouse beneficiary cannot convert an inherited traditional IRA to a Roth IRA.

How is an inherited Roth IRA different for a non-spouse beneficiary (such as a child or grandchild) than an inherited traditional IRA? A Roth IRA must still be withdrawn within 10 years; but all the withdrawals are tax-free. Also, there are no RMDs required for the beneficiary because Roth IRAs do not have RMDs.

There is an added benefit to leaving a Roth IRA to a grandchild who is under the age of 18 — the age of majority in most states. If a 5-year-old inherits a Roth IRA, the 10-year clock does not start ticking until the grandchild turns 18, thereby leaving the money in the Roth IRA to grow and compound for 23 years (13 years until age 18 plus the 10-year rule). One of the most powerful benefits of a Roth IRA is the growth and compounding that occur over many years as a tax-free account. One caveat: When a minor child inherits an IRA, a guardian must be named to manage the account. This is an inconvenience, but it is not usually a problem.

Spousal beneficiaries

If you name your spouse as a beneficiary, he/she can roll your traditional or Roth IRA into their own. If they do not already have an account, a new account will be opened for them. They are allowed to convert a traditional IRA to a Roth IRA. They will be required to take RMDs (rules vary depending on the age of the deceased and the spouse), but the 10-year rule does not apply to spousal beneficiaries.

The spousal beneficiary rules also apply to a beneficiary who is disabled or chronically ill, a minor child of the deceased IRA owner (not a grandchild), or someone who is less than 10 years younger than the deceased IRA owner.

Charities

If you name a charity, or several, as the beneficiary of a traditional IRA, the charity will not pay any taxes. If you have a diversified estate — such as a traditional IRA, a Roth IRA, a taxable account, and real estate — and you want to leave a portion of your estate to a charity, name the charity as the beneficiary of your traditional IRA. Do not leave a Roth IRA to charity because it is already tax-free and is a more valuable asset to leave to children or grandchildren.

Do not combine people (such as children or grandchildren) and a charity on a beneficiary statement for a traditional IRA or a Roth IRA. If you have a $500,000 traditional IRA and you want to leave it equally to four children and a charity, put $100,000 into a separate traditional IRA account for the charity and name your four children as beneficiaries on the $400,000 account. If a charity is named as a beneficiary along with people, there can be complications, and the 10-year rule may be nullified due to the charity.

Risks

All strategies have risks. If an IRA is left to a minor, he/she may decide to deplete the account at age 18. Of course, this can happen at any age for older beneficiaries. In my experience, this rarely happens because the beneficiary wants to honor the original owner, and is cautious when making financial decisions.

Another risk involves leaving an IRA to a spouse who later remarries. If the spouse who inherits the IRA names the new spouse as the beneficiary and then dies, the new spouse can name his/her children or grandchildren from a prior marriage as beneficiaries. The unfortunate result of this is that the children or grandchildren of the original IRA owner may be left out.

Double check

Naming a beneficiary on your traditional IRA or Roth IRA is an important decision. The beneficiary designation is not influenced by your will or trust. It is a stand-alone legal document that will be followed, even if it contradicts your other legal documents. Review the beneficiary statements for your IRAs, 401(k)s, life insurance policies, annuities and any other accounts where you may have named a beneficiary. Make certain every one of them conveys your wishes and keep a copy in a master folder with other important estate planning and financial documents.

Donna Skeels Cygan, CFP®, MBA, is the author of “The Joy of Financial Security.” She owned a fee-only financial planning firm in Albuquerque for over 20 years before recently retiring. She welcomes emails from readers at donna@donnaskeelscygan.com.