To secure the maximum amount in monthly Social Security retirement benefits, Americans must wait until full retirement age to start receiving their payouts. Results from a 2023 survey show that most of today's workers know about this stipulation - and yet the vast majority say they’re willing to file for their Social Security benefits early anyway.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which went into effect in 2020, changed how beneficiaries of inherited retirement accounts must withdraw these funds. The Act’s passage made it more difficult for individuals to pass their retirement savings on to their heirs without tax liability.
The 10-Year Rule
Generally speaking, beneficiaries of retirement plan accounts and Individual Retirement Accounts are subject to required minimum distribution (RMD) rules. Most people who inherit this type of retirement account now must withdraw all the funds from that account within 10 years. Exceptions to this include the following:
- Spouse of the original account owner
- Minor children of the original account owner
- Individuals with disabilities or chronic illness
- Beneficiaries who are not more than 10 years younger than the original account owner
Alternatively, individuals who inherit these accounts can withdraw all funds from the account at once (a lump sum) within 10 years. However, they must include these withdrawals in their gross income and pay taxes on these funds.
Why the 10-Year Time Limit?
Previous to this new rule, you had the option of withdrawing a small amount from an inherited retirement account each year. You could then leave the remainder to continue growing – tax-free – for as long as you lived. That is, the heirs could “stretch” the life of the account over time (this is where the phrase “stretch IRA” originates). From the perspective of Uncle Sam, stretch IRAs have meant less tax revenue.
Now that heirs must empty inherited retirement accounts within 10 years, the timeframe for paying taxes on them is more immediate. That is, they are paying taxes on the entire account over a decade instead of over the course of their lifetime. This 10-year period is also more desirable to the IRS for another reason. The funds are less likely to remain in this type of account, growing tax-free, for the next generation of heirs.
Rethinking How Your Retirement Funds Will Pass to Your Heirs
For many people receiving this type of inheritance, they are often at their greatest or highest income-earning period. As a result, because they are not allowed to delay withdrawing money from these accounts, they may be pushed into a higher tax bracket. In turn, that means they will likely have to pay more in taxes. You may want to help your heirs avoid this.
Given the new 10-year rule and tax implications, many people have been rethinking their estate plans. They are considering options that will help minimize taxes paid by their loved ones. One such option is converting retirement accounts to Roth IRAs.
What Is a Roth IRA and Why Might Converting Be an Attractive Option?
Roth IRAs are retirement accounts funded with post-tax funds. In other words, you have already paid taxes on the funds in the account prior to depositing them. Once the money is in a Roth IRA, it grows tax-free, and those who inherit it receive it tax-free.
For many seniors, this can be an attractive option. Although you will have to pay taxes upfront on the amount you are converting into a Roth IRA, you will likely be taxed at a lower tax rate if you are in your lower income-producing years.
Note, however, that the 10-year rule still applies to heirs (as do the exceptions).
Other Rules You Should Keep in Mind
In addition, there are other “rules” you should be aware of when considering this conversion option. One is that a successful conversion must occur within 60 days. In other words, you must transfer or roll over your retirement account funds within 60 days to the intended Roth IRA account.
The “five-year” rule is another important rule worth understanding. Under this rule, any funds you take out of the Roth IRA may be subject to income tax if the account is less than five years old when you make a withdrawal. So, if you anticipate needing these funds in the near term, then a Roth IRA conversion may not be for you.
Meanwhile, if you die less than five years after converting to this type of account, the beneficiary you named will miss out on the favorable tax treatment. That is, they will have no choice but to pay taxes on the funds they inherit through your Roth IRA account. Bearing this in mind, you may opt against converting to a Roth IRA if your life expectancy is under five years.
When to Consider a Roth IRA Conversion
You may decide a Roth IRA conversion is right for you. If so, you should consider when is an ideal time to put it into action. Generally, the best time to consider a Roth IRA conversion would be right after retirement but before you start taking RMDs. This is because you will usually be in a lower tax bracket during this time period.
Note that recent legislation (the SECURE 2.0 Act) increased the age at which you must start RMDs. As of January 1, 2023, you now have until age 73 to implement this option. The RMD age is due to change yet again, to age 75, in 2023.
Additionally, the original owner of a Roth IRA is not subject to RMDs for the Roth IRA. So, if you are the account owner and don’t yet need to access the funds, you do not have to withdraw them. You can bypass the RMD requirements that would have been in effect in the account from which you are converting.
Connect With Your Attorney
Conversions to Roth IRAs are not appropriate for everyone. This option can be a very effective way to leave your retirement funds tax-free to your loved ones. However, there are many moving parts to consider.
In fact, the rule changes have confused so many taxpayers that the IRS delayed some of them for inherited retirement accounts.
If you are thinking about a conversion, consult with a tax professional and your estate planning attorney. They can help you understand the process, the potential tax consequences, and what it means for your estate plan and heirs.