Your tax bill will be accelerated according to the new law
From Carla Fried
Rate.com Financial News Editor
Of the many changes made by the SECURE Act of 2019, one of the most important governs how those who inherit retirement accounts make distributions. From 2020, new beneficiaries without a spouse will only have 10 years to empty the account. Under old tax law, such beneficiaries could “stretch” their payouts over their entire lives as long as they made Minimum Annual Distributions (RMDs) based on an IRS formula tied to their life expectancy.
The new law does not change the rules for dealing with spouses’ heirs. Spouses still have a variety of stretch options. Other exceptions are disabled or chronically ill beneficiaries, people who are not more than 10 years old than the age of the deceased, and underage children of the deceased, but only until they are 18 years old.
For example, under the old system, the first RMD for a 40-year-old non-spouse (such as a child, grandchild, sibling, or nice neighbor next door) who inherited $ 100,000 would have been $ 2,294. The formula would slightly increase the payout percentage each subsequent year, but RMDs could remain for the rest of the beneficiary’s life. To be clear, anyone who inherits a retirement account can empty it all into one large withdrawal, but the law only required small annual withdrawals to please the IRS.
Under the new rule, an IRA or $ 401 (k) of $ 100,000 inherited from someone other than a spouse must be drained within 10 years of the year the owner dies. No stretching allowed.
If the money is in a traditional retirement account, each dollar withdrawn is counted as taxable income in the year of withdrawal.
10 year rule, but no RMDs
While the new law mandates a 10 year payout period, there are no annual RMDs. It is only important that the account is empty at the end of the 10-year window. Failure to do so will result in the IRS penalizing 50% of the remaining amount.
Inherited IRAs can get messed up with financial help
One consequence of compressing the withdrawal into a 10 year window is that adult children may have to make large payouts when their children apply for college. Money in a retirement account is not included in the financial assistance formulas. But retirement account distributions do.
They also affect Medicare premiums and Social Security taxation
According to a study by the wealth management company United Income, one in four recipients was over 61 years of age when they received their inheritance in 2016. This also includes spouses who do not have to worry about the 10-year rule. But since many people are living in the late 80s and 90s today, it is reasonable to assume that many children will be in their late 50s or early 60s when they receive an inheritance.
If the intention is to start Medicare at age 65, the Medicare Part B premium will be based on income reported at age 63.
If a large payout is made from an inherited traditional IRA or 401 (k) at 63, it could mean you owe a higher Medicare Part B monthly premium at 65. (The premium is recalculated every year based on a two-year review of your reported income.)
And the tax treatment of social security benefits also depends on the reported taxable income. Here, too, a distribution from an inherited pension account could have an impact on the taxation of social security benefits.
The conversion option
If you expect to leave a significant amount in retirement accounts, you might consider a Roth conversion, which involves transferring money from a traditional IRA to a Roth IRA or a traditional 401 (k) to a traditional IRA with a broker and then it will be moved to a Roth IRA.
You have to pay tax on the converted amount. So if you are still in a high tax bracket, this may not be advisable. As just explained, if you are already moving in, you need to consider the potential cost of your Medicare Part B premium and possibly your Social Security benefit.
The payoff is that once the money is in the Roth IRA, your heirs will still be subject to the 10 year account emptying rule, but will not owe any taxes on the amount you converted. And as long as the Roth account is five years old – from the time you opened the Roth account – you can also withdraw income tax-free.
If you have multiple illegitimate heirs with very different tax backgrounds, consider leaving more of the Roth heirs who are already in a high income tax bracket and using traditional heirs with a lower tax rate. Just remember to think through the after-tax net inheritance for everyone.
Turn head? Working with a consultant who is experienced in handling all of the moving parts is key.
Or maybe you consider spending more from the accounts now. To you of you. Or on her. Yes, this has tax implications for you (see above on: Working with a Tax Professional), but it’s an effective way to cut down on what’s left to inherit while potentially having more fun now or helping the younger generations for to save retirement. You could even give away money to fund a Roth IRA. Or help out with a down payment fund for a home.
(Rate.com/research/news covers the worlds of personal finance and residential real estate.)
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