Inheriting IRAs and TSP Gets More Complicated for Non-Spousal Heirs Under SECURE Act

As a result of the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019, it has become more complicated for non-spousal beneficiaries to inherit IRAs and the Thrift Savings Plan (TSP) from their owners and participants.

This column discusses the new rules associated with the SECURE Act that affect IRA owners and TSP participants who name non-spousal beneficiaries of their accounts.

Before discussing the new inheritance rules resulting from the SECURE Act passage, it is important to review the pre-SECURE Act rules for bequeathing TSP and IRAs.

A TSP participant can name any individual as the beneficiary of his or her TSP account. However, upon the death of the TSP participant, only a spousal beneficiary is allowed to keep the inherited TSP account in the deceased spouse’s TSP account. A non-spousal beneficiary is required to withdraw the inherited TSP account within five years of the TSP participant’s death. This includes both the traditional and the Roth TSP accounts.

The problem associated with withdrawing the traditional TSP account within five years of the traditional TSP participant’s death is that full federal income and, in most states, full state income taxes are due in the year(s) of withdrawals. The problem with withdrawing the Roth TSP account within five years of the Roth TSP participant’s death is that while no income taxes are usually due upon withdrawing the Roth TSP account, the withdrawn Roth TSP account can no longer grow tax-free.

An alternative for a non-spousal beneficiary to withdrawing the traditional TSP and Roth TSP accounts is for the non-spousal TSP beneficiary to request a direct transfer of the inherited TSP account to an inherited (also known as a “death” IRA). The traditional TSP would be directly transferred to a traditional inherited (“death”) IRA while the Roth TSP would be directly transferred to a Roth inherited (“death”) IRA.

Before the passage of the SECURE Act, the traditional or Roth IRA inherited (“death”) IRA owner had the option of taking mandatory required minimum distribution (RMDs) calculated based on his or her life expectancy. In so doing, the inherited IRA owner would receive each year his or her RMD, but any remaining IRA assets in the inherited IRA would continue to benefit from years – decades – of tax-deferred (traditional) or tax-free (Roth) compounding growth. For example, a 24-year-old heir of her grandfather’s TSP account could RMD payments over about 60 years, the life expectancy of a 24 year old. Hence the name “stretch” IRA.

But with the new rules resulting from the SECURE Act passage, non-spousal traditional and Roth IRA heirs will have to withdraw the inherited IRA assets entirely within 10 years following the death of original IRA owner, rather than based on their own life expectancy.  There are no annual RMDs for non-spousal heirs under the SECURE Act; rather, the inherited IRA is to be emptied by the end of the tenth year following the year of death.

The new law took effect for IRA owners dying after Dec. 31, 2019, meaning that any IRAs inherited by non-spousal heirs before Jan. 1, 2020 still benefit from the prior law. Any non-spousal heir who directly transferred a traditional IRA or a Roth IRA of an IRA owner who died before Jan. 1, 2020 into an inherited IRA may continue to receive lifetime payments based on his or her life expectancy.

The SECURE Act’s halt on lifetime payments to non-spousal heirs such as grandchildren obviously has upset many IRA owners and TSP participants, especially those with $1 million plus account balances. Perhaps the biggest criticism among retirement savers is that Congress cannot keep its word on the highly advertised benefits associated with saving for retirement for one’s self and one’s family. The revised rules especially affect Roth TSP and Roth IRA owners who paid taxes “upfront” on their contributions, or who paid taxes on converting their traditional IRAs to Roth IRAs, with the intention of bequeathing lifetime Roth IRA accounts to much younger heirs.

The SECURE Act does list beneficiaries who are exceptions to the 10-year mandatory payout. They are called “eligible designated beneficiaries” and include:

• Surviving spouses. IRA heirs who are surviving spouses are not affected by the new rules. They still can benefit from the lifetime payout option.

• Minor children (but not grandchildren) up to the age of 18 or 21 (depending on what state the child lives in) or up to age 26 if the child is in school. But once the child reaches the appropriate age, the 10-year withdrawal period begins as the following example illustrates:

Joseph, age 40, has a traditional IRA currently worth $500,000. Joseph has named his daughter, Emily, age 12, as beneficiary of his IRA. Joseph dies suddenly. The trustees for Emily elects to withdraw the inherited IRA over Emily’s life expectancy (72 years). However, once Emily becomes age 18, the inherited traditional IRA must be paid out in its entirety by the time Emily becomes 28 years old. 

• Beneficiaries who are disabled or chronically ill, as defined by the IRS.

• Beneficiaries who are no more than 10 years younger than the IRA owner.

Given the effect of the new rules for bequeathing traditional IRAs and Roth IRAs to non-spousal heirs under the SECURE Act, the following are some recommendations for TSP participants and IRA owners to consider to get around the end-of-10 year lump sum mandatory payment:

• If married, make one’s spouse the heir to the IRA. Surviving spouses still have favorable options as to what to do with an inherited IRA from their deceased spouses. For example, a surviving spouse who inherits a traditional IRA or a Roth IRA could retitle the account in his or her name, and not take payouts from the traditional IRA until age 72. The spouse could then leave the account to children heirs who would be subject to a 10-year deadline for withdrawing their inherited IRA assets.

• Review existing IRA trusts. Those IRA owners who have established and named trusts as beneficiaries of their IRAs need to have these trusts reviewed by a qualified attorney. This is because certain types of trusts – in particular, “accumulation” trusts – make little sense under the SECURE Act and the unfavorable tax rates that trusts are subject to.

• Consider life insurance as an alternative to retirement assets in order transfer wealth to heirs. The SECURE Act favors life insurance over IRAs as a tax-efficient way to move assets from the older generation to the younger generation. This is because life insurance death payouts can be free of both income and estate taxes. In paying the premiums for the life insurance policy, the IRA owner could take distributions from the IRA (in the case of the traditional IRA, an IRA owner over age 72 must take at least the required minimum distribution (RMD), and more if necessary) in order to pay the life insurance premiums. Life insurance can also be more flexible than an IRA if the IRA owner wants to leave assets to a trust. Finally, since the IRA owner needs a lifetime cash value or permanent life insurance policy (and not a term life insurance policy which is in effect for a limited number of years), it is important that the IRA owner to be aware of the fees associated with the permanent (cash value policy). These fees can be rather large, especially with equity- (stock) oriented) permanent life insurance policies. Also, it is also to know whether the insurance company has the right to raise the fees in the future as the insured gets older and by how much.

For traditional IRA owners who have non-spousal beneficiaries and who choose to do nothing under the new rules resulting from the SECURE Act passage, one suggestion would be to name multiple beneficiaries of their IRAs. In so doing, following the death of the IRA owner, there will be a lump sum payment of the inherited IRA assets to each beneficiary. While a lump sum payment of traditional IRA assets is taxable to the beneficiary, and if large enough, could result in a beneficiary being pushed into a higher tax bracket in the year that the inherited IRA assets are received, the overall tax liability will be minimized if there are multiple traditional IRA beneficiaries.