The Secure ACT, and how the 10-Year Rule Will Cost You More Taxes!
It used to be the 5-year rule—but now the one ring to rule them all –the 10-year rule.
What is the 10-year rule and why is it important to YOU? After 2020, and for most non-spousal beneficiaries, pay attention. The 10-year rule will cost you more in taxes if you have pre-tax retirement accounts.
Do You Have a Pre-Tax Retirement Account?
If you have a pre-tax retirement account, such as an IRA or a 401k/403b, you need to know about the 10-year rule.
After all, folks who read this blog are supersavers and likely will need to leave some (or a lot) of their money behind. If you are going to leave your pre-tax money to charities (or to a CRUT as a Stretch IRA Alternative), then you don’t need to be concerned about the 10-year rule. They take it all year one and don’t pay any taxes.
If you are going to leave your pre-tax money behind to your spouse, then you don’t need to worry about the 10-year rule. Spouses are eligible designated beneficiaries, which I’ll discuss below. But remember, if you have a large IRA or 401k, you may want to do a cascading beneficiary plan via disclaimer planning (or even a spray trust). I don’t think I’m going to talk any more about those advanced planning techniques for the time being…
But if you have a large pre-tax retirement account you are not planning to leave to your spouse or to charity, then pay attention! The Secure Act changed how you leave your pre-tax accounts to your kids.
If you want to see the tax and net worth implications of these stretch IRA comparisons vs the 10-year rule, you will note that this change was made so the government will collect more in taxes. More in taxes, less for your heirs.
Secure Act and the 10-year Rule
There actually is no such thing as a “stretch” IRA, but it is just lingo to explain a concept. Here is the concept: you can leave your IRA behind for your kids and they can “stretch” it over their remaining life expectancy. So, say for instance they were 40 and had a forty-year life expectancy when they inherited your IRA. The first year, they would take 1/40th, then 1/39th the second year, then 1/38th, 1/37th, etc. You can see that the IRA will grow tax-deferred over time and will be worth quite a bit even 30 or 35 years later when you are taking 1/5th, 1/4th, 1/3rd, half, then, on the final year of the original life expectancy, they finally drain the account.
That’s quite a mouthful, but most people may not understand how the stretch actually used to work. If you read the above, now you do! You get the life expectancy one time from an IRS table, and then you subtract one from the denominator year-after-year thereafter.
Now, after the Secure Act, it is the 10-year rule. RIP Stretch IRA (at least to your kids). Aside from a CRUT which is mentioned above, Life Insurance and Roth Conversions are Stretch IRA Replacements.
The 10-year rule means there are no more required distributions every year, just that the entire account needs to be drained by the 10th year after the death of the pre-tax owner. So, you could take out 1/10th every year, or you could drain it all the last year.
Smart Options for Withdrawing an Inherited IRA Under the 10-Year Rule
What are the smart options for withdrawing an inherited IRA with the 10-year rule in place? If you have variable income, take more from the inherited IRA when you have low-income years. And if it is a small amount in the IRA and won’t bounce you up tax brackets (or if you are already in the top tax bracket and don’t expect that to change), keep tax-deferring it until year 10 and then take it all out in one year. If you want to have the lowest chance of the intertied IRA bouncing your income above the next tax bracket (and thus costing you extra in taxes), take out 1/10, then 1/9, etc.
Roth IRAs and the 10-Year Rule
With Roth IRAs, it makes sense to let it grow tax-free for 10 years and then drain it all the last year. It is tax free to your heirs, which is why heirs love Roth money. They can take it if they need it, or let it sit there compounding tax-free for 10 more years before they take the entire kit and caboodle.
Eligible Designated Beneficiaries
Let’s change gears here and discuss who can still use the Stretch IRA. The Secure Act didn’t get rid of the stretch so much as it added another concept, that of eligible designated beneficiaries.
There are a few designated beneficiaries who are determined to be “eligible” to not be forced to use the 10-year rule.
First off, a beneficiary is someone (or something like a charity or a trust, or—if you are uniformed—your estate) you list on your beneficiary form of your retirement account. Next a, designated beneficiary is someone with a pulse.
Charities and trusts will use the 5-year rule because while they may be beneficiaries, they don’t have a pulse and thus are not designated beneficiaries.
Above, you can see from Kitces, there are beneficiaries that can be non-designated (because they don’t have a pulse) and non-eligible (because they don’t meet a criteria to be eligible).
Who Is Eligible Designated Beneficiary?
To be eligible to not use the 10-year rule, you must fall into one of the following 4 eligible exceptions:
- Spouses. Spouses keep their broad ability to do just about anything they want with IRAs. They have always had the most flexibility to take it as their own, to stretch it as an inherited IRA, or other features depending on if RMDs have begun or not.
- Beneficiary less than 10 years younger than Owner.
- Chronically ill (2 of 6 ADLs) or Disabled (note disability uses strict IRS criteria but leaves open the possibility of stretch IRA trusts for disabled folks, which is a must)
- Less than the Age of Majority (or still in school until 26 years of age). You can stretch it until you hit the magic age at which time the 10-year rule starts. So this is just a deferral of the 10-year rule. And it is only for children of the account owner, not for grandchildren or other non-child youths.
Trusts and the 10-Year Rule
Note that trusts are listed in all 3 of the categories above. Lovely. Obviously this is going to get really hairy really quickly, but if you want a short cut for trusts, then think about it this way:
Eligible Trusts likely will only be special needs trusts for folks who meet IRS disability requirements. Fortunately, these can be conduit (see-through) trusts so they keep the stretch (tax-deferred growth) and don’t trigger the loss of healthcare and other benefits.
All other Conduit (See-Through) Trusts which were intended to get Stretch treatment for the beneficiaries prior to 2020 will likely need to be changed. Now, if you want the “control” you get from a see-through trust, you will likely loosely 40% of the trust to taxes. That is the cost of control.
Accumulation trusts will also face 40% loss of taxes.
The alternative is a multi-generational spray trust where the income every year is sprinkled among many different beneficiaries depending on their tax brackets. This is the most efficient (and complicated) way to save in taxes.
The main point here is: Do Not Put Trusts as Beneficiaries of Retirement Accounts. Unless you have spoken to a (very) good estate attorney. Yeh, that guy who put together your will… he does not count and he will lose you 40% of your retirement account to taxes.
How Much Inheritance do you Lose with the Loss of the Stretch IRA?
That’s a great question! Say you have to use the 10-year rule instead of a Stretch IRA, how much money does your heir lose?
I wrote a whole blog on the topic. Of course, the answer is “it depends” because this is personal finance after all. But if your middle tax bracket heir was going to optimally stretch a good-sized IRA, you might lose half of the value to taxes and loss of deferred growth. RIP Stretch IRA. Most heirs just cash out the IRA as soon as you die, though, so remember there are optimal ways to leave money behind to heirs.
The Death of the Stretch IRA
A Charitable Remainder Uni-Trust (CRUT) is a very interesting idea. If you have some charitable intent and want to leave a yearly income behind for your heirs, this might be just the thing for your large IRA. And guess what, you can name a Donor Advised Fund as your charity which means the remainder goes to your grand-kids for gifting.
Taking money out for life insurance, especially if you are bumping up against estate taxes and your heirs are in high tax brackets is also a consideration. So, the planning option is to pay taxes now to pull out money to put into a second-to-die GUL in a Life-Insurance Trust. This gets money out of your estate and into a tax-free benefit for your heirs. After Roth conversions, believe it or not, this is an amazingly powerful use of Permanent Life Insurance and one of the appropriate uses for high income earners.
I mentioned a spray trusts above just briefly too. These are advanced planning techniques and may be appropriate for a large family. Spray trusts are pretty complicated and you need a really good estate attorney to plan these so that they don’t blow up and become fully taxable at trust tax rates.
Disclaimer Estate Planning
Partial Roth Conversions
But the clear winner of the is the partial Roth conversions. Consider at least debulking your Roth IRA if you have a lot of pre-tax retirement money, or consider a series of full on partial Roth conversions during your Tax Planning Window.
Above, you can see current tax law (in black) and what the tax law will be in 2026 when the Tax Cut and Jobs Act expires. You can see between 12 and 24% there is a clear spot for partial Roth Conversions. If you do nothing but wait for a couple years, it will save you 3-4%. But there is a deeper, more important reason to do them.
IF you have not read my blog on a series of partial Roth Conversions during your Tax Planning Window, please do so. It is the best blog on the internet on the topic, and it has been updated for the Secure Act.
Miscellaneous 10-Year Rule Considerations
Since you have until December 31st of the tenth year following the year of death, you actually have 11 years you can take a distribution, since you can take a distribution the year of death as well.
If you inherit an inherited IRA, you are subject to the 10 year rule. Even if you are an eligible designated beneficiary, since inherited IRAs are not considered retirement accounts, you must fully drain the account. Used to be able to continue the stretch, or step in the shoes of the person inheriting the account.
Penalty for Non-Compliance
50%. The IRS does not want your to miss your required withdrawals from retirement accounts. If you do, the penalty is 50%.
You leave all the money to your spouse, but when he or she dies, then it all goes to the kids at once. If you leave half to the kids at the death of the first spouse, they might get two 10 year “mini-stretches.”
Above, you can see when the first spouse dies, the children are left as contingent beneficiaries on the beneficiary forms, and the surviving spouse can disclaim any amount he or she doesn’t need to the children. This starts a 10-year clock on the disclaimed amount. Hopefully, the second spouse will die more than 10 years later, so the rest of the IRA gets another 10-year clock.
Implications of the 10-Year Rule
Increased Taxation for Heirs. As there are no more RMDs for most IRA beneficiaries, they must take out the deferred income from the pre-tax accounts over 10 years. This may result in bracket creep, where the income sits on top of their earned income forcing them into higher tax brackets and resulting in greater tax exposure to the inherited funds.
Summary: The 10-Year Rule and Your Retirement Accounts
The 10-Year Rule is now the law of the land. If you were considering leaving a Stretch IRA behind as a legacy, think again! What about a CRUT or Life Insurance as options?
Most beneficiaries of inherited IRA will now be forced to withdrawal the money over 10 years using the 10-Year Rule. Required Minimum Distributions (RMDs) are no more with inherited IRAs. You now must drain the account by the end of the 10th year.
Retirement plans are not intended by congress to be vehicles for generational wealth. Prior to the Stretch IRA, the 5-Year Rule was the law of the land. The Supreme Court determined that inherited retirement accounts are, in fact, not retirement accounts and subject to loss by creditor. Many smart folks were predicting it was only a matter of time before the Stretch IRA would be repealed. Now these same folks are saying it is only a matter of time before the 10-year rule goes away and is replace by the 5-year rule.
Fundamentally, these changes are happening because congress wants to get the money out of tax-deferred accounts so they can get paid taxes. Also, the money that is forced out is spent or forced into a taxable account with ongoing tax drag. Win-Win for the government.
But the 10-year rule is all the more reason you need to pay attention to your retirement accounts in order to minimize your and your heir’s taxes. Every dollar you don’t pay the government is another one you get to spend or give away.