How to Leave Your Heirs an Inheritance, Not a Tax Bill

As a result of the passage of SECURE Act 1.0 in December 2019 and SECURE Act 2.0 in December 2022, it has become more difficult for federal employees to leave their retirement savings to their children and to their grandchildren. Retirement savings accounts include the Thrift Savings Plan (TSP) and IRAs.

Most IRA beneficiaries who are non-spouses – this includes children, grandchildren and other individuals who are more than 10 years younger than the IRA owner – must draw down their inherited IRAs within 10 years of the death of the IRA owner.

Since most withdrawals from traditional IRAs are both federal and state taxable, the IRA beneficiary must pay all the taxes due within the required 10-year payout period. Prior to January 1, 2020 (at which time when SECURE Act 1.0 became law) when a traditional IRA owner died, any IRA beneficiary had the option of withdrawing their inherited IRA over their life expectancy. By withdrawing the traditional IRA over their life expectancy, the IRA beneficiary could receive a lifetime income and spread the tax liability over decades.

With respect to the TSP, it has always been the rule that a non-spousal beneficiary of the traditional TSP had to withdraw his or her inherited TSP account within five years of the TSP participant’s death.

However, the non-spousal beneficiary had the option (and still has) of requesting a direct transfer of the inherited TSP account to an inherited IRA, also called a “death” IRA. In so doing, the non-spousal beneficiary could draw down the inherited IRA over the beneficiary’s life expectancy. That was the case before January 1, 2020. But starting January 1, 2020, all non-spousal inherited IRAs must be drawn down within 10 years of when the inherited IRA was established.

The change in the deadline as to when non-spousal beneficiaries have to draw down their inherited IRAs has many grandparents and parents rippling up their estate plans. New trusts are being drawn up to maximize family after-tax wealth. Some grandparents and parents are making immediate moves including embarking on a program of Roth IRA conversions.

There is a large amount of money and potential taxes at stake. According to the Investment Company Institute, Americans held 12.5 trillion dollars in IRAs as of March 31, 2023. 52 percent of households headed by someone aged 65 or older own an IRA.

When a traditional IRA owner converts his or her IRA to a Roth IRA, any taxes that would be due when the IRA is withdrawn are paid upfront in the year the IRA is converted. Once the money is in the Roth IRA, it grows tax-free. Any named beneficiary can withdraw the inherited Roth IRA tax-free.

While the Roth IRA beneficiary would not have the option of withdrawing the inherited Roth IRA tax-free over their life expectancy (as they were able to do before January 1, 2020) and has to withdraw it within 10 years of the Roth IRA owner’s death, at least no taxes are due when the inherited Roth IRA funds are withdrawn.

Naming grandchildren as beneficiaries of traditional IRAs used to be a popular estate planning move before the passage of SECURE Act 1.0 in December 2019. Before the passage of SECURE Act 1.0, federal employees after they had retired from federal service could request a direct rollover of all or some of their traditional TSP to a traditional IRA with no tax consequences. They would then name their grandchildren as beneficiaries of their “rollover” traditional IRAs. The grandchildren could then upon receiving the IRA at the grandparent’s death, request a lifetime distribution of the inherited IRA based on the grandchild’s life expectancy.

However, the passage of SECURE Act 1.0 changed that. In particular, because of the 10-year payout requirement. Inherited traditional IRAs when entirely withdrawn could result in a huge tax bill, especially if the distributions fall during the grandchildren’s or their parent’s highest earning years.

Minor grandchildren may need to file a tax return to report the IRA payouts, and the income would likely be taxed at their parents’ tax rate under the “kiddie tax” rules. The result is that a traditional IRA is one of the least favorable retirement assets to leave to grandchildren.

Naming a child or grandchild as the beneficiary of a Roth IRA avoids some of the problems associated with the accelerated tax hit associated with an inherited traditional IRA.

But there are other considerations and questions when parents and grandparents plan their legacy for future generations. Here are a few of these considerations and questions:

Will the legacy be “squandered”?

By leaving an IRA outright to children or grandchildren, there is a danger that the children or grandchildren will see the IRA inheritance as a “windfall” and possibly be spent recklessly. This is the case even with the 10-year payout period. It is therefore important for parents and grandparents to talk to their children and grandchildren who they want to name as IRA beneficiaries as to how they would like them to use their inheritance. For example, as a downpayment for buying a house or to start a business.

Administrative hassles

Inherited IRAs come with complications for beneficiaries beyond the required 10-year payout. An inherited traditional IRA cannot be converted to a Roth IRA. No contributions can be made to an inherited IRA. An inherited IRA cannot be combined with one’s own “contributory” IRA or “rollover” IRA. If a minor is named as an IRA beneficiary, then an adult, for example, the minor’s parent, has to be named until the minor reaches the age of majority, which varies by state. In some cases, a guardian may need to be appointed by a court.

Is using a living trust a possible solution when grandchildren are named IRA beneficiaries?

Leaving an IRA in a trust could possibly solve the problem of a “spendthrift” beneficiary. With a trust, a trustee would distribute the money based on the terms the IRA owner sets out in the trust. But there can be some complications associated with a living trust. Anyone considering using a living trust as a beneficiary should seek the advice of an estate attorney. A trust may be appropriate in these situations: (1) An IRA owner wants to provide for a child of a prior marriage; or (2) The IRA owner leaves retirement plan assets to a child and the child is not capable of responsibly managing investments and/or asset distributions.