Inherited Retirement Plan? How to Understand Payout Rules

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With the passage of the SECURE Act, there have been changes in required payouts for beneficiaries on retirement plans and IRAs that have many people in a state of confusion.

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The retirement accounts that are affected by these rule changes include 401(k) plans, 403(b) plans, 457(b) plans and traditional IRAs and Roth IRAs. And keep in mind that with all but the Roth, these required payouts will trigger taxes.

Depending on when the original retirement plan owner dies, some of these beneficiaries have to pull the money out in five years, some have to pull the money out in 10 years while taking required minimum distributions (RMDs) for the first nine years, some get to pull the money out in 10 years without RMDs over the first nine years, some get to pull the money out over their life expectancy, and there’s even a beneficiary group that gets to stretch it over their life expectancy until they reach age 21, at which time they have to switch and follow the 10-year rule.

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It’s enough to make your head explode. Is there a simple way to organize and understand these rules so the beneficiaries can be prepared to know what rules and what category both they and their loved ones will fall under? The answer is yes.

A simple way to understand the different required retirement plan payouts is to start by dividing retirement plan beneficiaries into three groups:

Non-designated beneficiaries.
Non-eligible designated beneficiaries.
Eligible designated beneficiaries.

Non-designated beneficiaries, or NDBs, are easily identified because they are not people. For example, this could be an estate or a charity or a non-look-through trust.

With NDBs, if the IRA owner or retirement plan participant dies before April 1 of the year after they turn 73, better known as the required beginning date (RBD), the retirement plan proceeds must be withdrawn by the end of the fifth year after death, and there are no annual RMDs during this five-year period.

If the IRA owner or retirement plan participant dies on or after the required beginning date, RMDs must be taken over the deceased original retirement plan owner's life expectancy. This could allow for a much longer post-death payout than five years, which could help minimize taxes.

The next category, non-eligible designated beneficiaries (NEDBs), will represent the largest group of beneficiaries. This group includes adult children who are 21 years of age or older and grandchildren.

With NEDBs, if the original retirement plan owner dies before the required beginning date, there are no annual RMDs, but all the money must be withdrawn by the end of the tenth year after the original owner's death, with taxes applied. This is known as the 10-year rule.

For this same group, if the original owner dies on or after the required beginning date, then there will be annual RMDs based on the beneficiary’s life expectancy that must be taken for years one to nine with the entire account to be emptied by the end of the 10th year after death, with all applicable taxes applying.

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The final category of beneficiaries, the eligible designated beneficiaries (EDBs), have the sweetest deal since they are exempt from the 10-year rule, which means they can take their RMDs based on their life expectancy, which will normally result in a much smaller taxable distribution.

The two biggest groups that have this status would be a surviving spouse or a beneficiary not more than 10 years younger than the IRA owner, like a brother or sister. This can also include a beneficiary who’s older than the original IRA owner.

Other groups would include disabled individuals, chronically ill individuals and minor children of the original retirement account owner until they reach age 21, at which time the 10-year countdown would apply.

So that’s it. You can now identify which group you fall under and make sure you take your required retirement plan payouts appropriately to avoid penalties or paying unnecessary tax.

And while you’re at it, consider doing some planning on what you or your heirs can do to maximize the tax efficiency of your future withdrawals.

For example, while the original IRA owner is still alive, he or she might consider doing Roth conversions since the withdrawals would be tax-free for their heirs.

If you’re charitable-minded, consider leaving more of the pre-tax retirement money to a charity (a non-designated beneficiary) since the charity receives the funds tax-free. Then you could leave more of the non-retirement accounts to the heirs, which would trigger far less tax on withdrawals.

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And remember: Even if the beneficiary has already inherited the IRA, regardless of which of the three categories they fall into, they can always take out more than the RMD, which if done in years where they fall into a lower tax bracket, can reduce the overall tax impact.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Mike Piershale, ChFC, is president of Piershale Financial Group in Barrington, Illinois. He works directly with clients on retirement and estate planning, portfolio management and insurance needs.