“The SECURE Act changed the options that are available to designated beneficiaries. But, for those who inherited retirement accounts in 2019, the year 2020 might be a last chance to hang on to the older and more beneficial beneficiary distribution options.”
One of the most impactful changes made under the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) is the elimination of the life expectancy distribution option for designated beneficiaries. These changes are effective for designated beneficiaries who inherit retirement accounts after 2019. Those who inherit retirement accounts in 2019 are the last set of designated beneficiaries to benefit from the generally more beneficial pre-SECURE Act life expectancy options; but for some, certain steps must be taken during 2020 to preserve that benefit. This newsletter covers some of those steps.
Please note: Because a spouse beneficiary has the option of moving an inherited retirement account to the spouse beneficiary’s own retirement account, this article focuses on nonspouse beneficiaries.
Starting with the Basics: Who is a Designated Beneficiary?
When it comes to retirement accounts, terminology matters. And, identifying who is a designated beneficiary is a prime example.
A nonperson- such as an estate or charity- can be designated as a beneficiary of a retirement account; so can an individual. However, only an individual may be a designated beneficiary.[i]
A designated beneficiary generally has the option of taking distributions from an inherited retirement account over the designated beneficiary’s life expectancy. A nonperson beneficiary cannot, as a nonperson beneficiary has no life expectancy.
Exception for Trust Beneficiaries: A trust is a designated beneficiary, if certain requirements are met. These are defined under Treas. Reg. §1.401(a)(9)-4, Q&A-5. If these requirements are met, the life expectancy of the oldest beneficiary of the trust may be used for required minimum distribution (RMD) purposes. Retirement account owners and beneficiaries should consult with an attorney who is proficient in the area of distribution planning, for assistance with determining whether a trust is qualified to be a designated beneficiary.
Continuing with the Basics: What is the Required Beginning Date?
When determining the distribution options available to a beneficiary who inherited a retirement account before 2020, one must first determine if the retirement account owner died before the required beginning date (RBD). The RBD is the deadline by which a retirement account owner must start taking RMDs.
For beneficiaries who inherit retirement accounts before 2020, the RBD is April 1 of the year that follows the year in which the retirement account owner reached age 70 ½.[ii]
For employer sponsored retirement plans that permit deferral of RMDs past age 70 ½, the RBD is the later of:
- April 1 of the year that follows the year in which the participant reached age 70 ½, or
- April 1 of the year that follows the year in which the participant separated from service with the plan sponsor.
This means that April 1, 2020 would have been the RBD for IRA owners who reached age 70 ½ in 2019, as well as plan participants for whom the first RMD year was 2019.
Distribution Options for Designated Beneficiaries Who Inherit Retirement Accounts before 2020
A designated beneficiary who inherits a retirement account before 2020, is eligible to take distributions as follows:
- If the retirement account owner died before the RBD:
(a) over the designated beneficiary’s life expectancy; which is the default option under the RMD regulations, or
(b) under the 5-year rule.
5-year rule: Under the 5-year rule, distributions are optional until December 31 of the 5th year that follows the year in which the retirement account owner died, at which time the entire remaining balance is the RMD and must be distributed.
- If the retirement account owner died on or after the RBD, the designated beneficiary may take distributions over the longer of:
(a) the decedent’s remaining life expectancy, or
(b) the life expectancy of the designated beneficiary.
Life expectancy rule: When distributions are made under the life expectancy option, they must begin by December 31 of the year that follows the year in which the retirement account owner died.
The life expectancy option could be limited by the provisions of the governing plan document or IRA agreement and when there are multiple beneficiaries of a retirement account. In those cases, a designated beneficiary might need to take action, to preserve the life expectancy option.
Reminder: For 2020, the Coronavirus Aid, Relief, and Economic Security Act waives RMDs for IRAs and defined contribution plans- for account owners and beneficiaries.
Action Might Be Needed in 2020 to Preserve Designated Beneficiary Options for 2019 Beneficiaries
If a designated beneficiary is the sole primary beneficiary of a retirement account, and the IRA agreement or plan document defaults to the life expectancy option, then the life expectancy option is automatically preserved. But, if that is not the case, there are factors that could limit the designated beneficiary’s options. The good news is, for 2019 beneficiaries, these limitations can be overridden if the appropriate action is taken in 2020. The following is a high-level explanation of these limitations and how they can be overridden.
Limitation 1: When There Are Multiple Designated Beneficiaries
If there are multiple designated beneficiaries of a retirement account, the life expectancy of the oldest beneficiary is used for beneficiary RMD purposes. This puts younger beneficiaries at a disadvantage, as it forces them to take larger RMD amounts which depletes the account faster than if they were eligible to use their own life expectancies; thus, reducing the period over which eligible amounts may continue to grow tax-deferred.
Solution for 2019 beneficiaries: Perform separate accounting by December 31, 2020
If separate accounting occurs by December 31 of the year following the year of the account owner’s death, each designated beneficiary may use his own life expectancy.[iii]
Please note: Beneficiaries must contact the plan administrator or IRA custodian in advance of the deadline, for assistance with meeting the trustee or custodian’s operational and documentation requirements for performing separate accounting.
Example: Janet died in 2019. Her 65-year-old cousin Carl and her 25-year-old nephew Jonathan are the beneficiaries of her Roth IRA; to be shared equally.
Assuming a balance of $200,000, of which no more than RMD amounts are taken each year, and a rate of return of 5%, the total distribution amounts would be:
Scenario A: If separate accounting does not occur by December 31, 2020- then distributions would be made over Carl’s life expectancy.
- Carl’s total distributions would be approx. $173,596.29
- Jonathan’s total distributions would be approx. $173,596.29
Scenario B: If separate accounting occurs by December 31, 2020, Carl’s share would be distributed over Carl’s life expectancy and Jonathan’s share would be distributed over Jonathan’s life expectancy.
- Carl’s total distributions would be approx. $173,596.29
- Jonathan’s total distributions would be approx. $561,608.37
Limitation 2: When There Are Multiple Beneficiaries That Include Individuals and Nonpersons
If there are multiple beneficiaries of a retirement account, and a nonperson is one of the beneficiaries, the account is treated as not having a designated beneficiary (except for certain trusts- See Exception for Trust Beneficiaries earlier).
This would require the inherited amounts to be distributed under the 5-year rule if the owner died before the RBD and over the remaining life expectancy of the decedent, if death occurred on/after the RBD. For Roth IRAs, the 5-year rule would apply regardless of the age of the owner at death.
Solution for 2019 beneficiaries: Have nonperson beneficiaries take full distributions of their share by September 30, 2020
The determination of whether a retirement account has a designated beneficiary is made by September 30 of the year that follows the year in which the retirement account owner dies. Any beneficiary that takes a full distribution or makes a full disclaimer of that beneficiary’s share by this September 30th date, is disregarded for purposes of determining the designated beneficiary.[iv] Reminder: Disclaimers must meet the requirements of IRC § 2518
Example: 45-year-old Tom died in 2019. His 50-year-old brother Harry and his estate are the beneficiaries of his Traditional IRA; to be shared equally.
Assuming a balance of $1,000,000, of which no more than RMD amounts are taken, and a rate of return of 5%, the total distribution amounts would be:
Scenario A: If the estate’s share remains in the account, both beneficiaries would be subject to the 5-year rule.
- Harry’s total distributions would be approx. $638,140.79
- The estate’s total distributions would be approx. $638,140.79
Scenario B: If the estate distributes its share by September 30, 2020- Harry would be able to take distributions over his life expectancy.
- Harry’s total distributions would be approx. $1,281,891.98
- The estate’s total distributions would be $500,000
Limitation 3: Plan Document Defaults to the 5-Year Rule
When a designated beneficiary inherits a retirement account from a plan participant who died before 2020 and death occurred before the RBD, the options are the life expectancy rule and the 5-year rule. However, while the general default under the tax code is the life expectancy rule, a plan document may default to the 5-year rule.
Solution: Override 5-year rule by moving the account by December 31, 2020
The 5-year rule can be overridden, by moving the inherited account to a beneficiary IRA which permits the life expectancy distribution option. For instance, if a 401(k) plan requires beneficiaries to use the 5-year rule, a beneficiary who inherited a 401(k) account under such a plan in 2019 may avoid that limitation by moving the assets – as a direct rollover – to a beneficiary IRA that permits life expectancy distribution, by December 31, 2020.
Update: The IRS recently announced that this deadline has been extended to December 31, 2021. See IRS Notice 2020-51.
Year of Death Matters Even More Going Forward
Much ado is made about the changes to beneficiary options made by the SECURE Act- and rightfully so, as they limit the distribution period to the new 10-year rule for designated beneficiaries. But, for those who inherited retirement accounts in 2019, there are still opportunities to take distributions under the life expectancy method. But advisors must be more careful than ever, when advising clients about beneficiary options, and one important cautionary step is to determine whether the account was inherited before 2020. This is because that- whether the account was inherited before 2020- drives the distribution options, and for accounts inherited after 2019, the more limited options under the SECURE Act applies.
[i] §1.401(a)(9)-4 Q&A 1.
[ii] IRC §401(a)(9)(C),
[iii] §1.401(a)(9)-8 Q&A 2.
[iv] §1.401(a)(9)-4 Q&A 4.
Denise Appleby is CEO of Appleby Retirement Consulting Inc., a firm that provides IRA tools and resources for financial, tax and legal professionals. She has over 20 years of experience in the retirement plans field, which includes providing training and technical consultation. Denise writes and publishes quick reference guides, booklets, and marketing tools for advisors. She has also co-authored several books. Denise is a graduate of The John Marshall Law School, where she obtained a Master of Jurisprudence in Employee Benefits and has earned 5 professional designations in the field of retirement account rules and regulations.
Go to www.applebyconsulting.com to learn more about Denise.