Inheriting a retirement plan has gotten complicated. How advisors can keep up

November 15, 2022 10:36 AM

The matter of coming into money has gotten messy, thanks to a 2019 law that refashioned what non-spousal beneficiaries must do with inherited retirement plans.

Throw in shifting and confusing directions from the Internal Revenue Service, and financial advisors face hurdles for clients aiming to leave a nest egg to the next generation. Add in an unexpected reprieve by the tax agency on distributions and stalled legislation aimed at curbing monster-sized Roth plans — an engine of tax-free wealth — and advisors face an opportunity. Lower stock and bond values can serve as a tail wind that puts assets into a plan at bargain prices.

The RMD mystery

Before 2020, heirs to individual retirement accounts and 401(k)s could "stretch" out required minimum withdrawals, or RMDs, over their lifetimes. That gave inheritances more time to grow significantly in value, sometimes over decades.

Since 2020, beneficiary heirs who aren't a spouse, minor child, disabled or sick person, or more than 10 years younger than the original owner must empty an inherited account within 10 years of the original owner's death, taking annual distributions along the way, according to a proposed Internal Revenue Service rule.

What's unclear to some financial advisors: whether RMDs are required for inherited Roth plans. At stake is how large an inheritance can get before it has to be cashed out.

Read more: Inherited a Roth retirement plan? Advice on withdrawals is all over the map

The RMD reprieve

Among the many surprises for heirs to retirement plans this year was the IRS's unexpected announcement in October that no penalties would hit beneficiaries who did not make required minimum withdrawals for 2022 and 2021. The reprieve appears to signal that heirs are off the hook for distributions for those two years, a stay that allows more time for appreciation — and a chance to boost a nest egg, even amid the downturn in stock and bonds.

Read more: Recent heirs to retirement plans win a surprise tax reprieve from the IRS

When 10 years is half as long

While a non-spousal heirs has to empty a retirement plan within 10 years, some beneficiaries have a much shorter leash of five years. A murky area in the 2019 SECURE Act (Setting Every Community Up for Retirement Enhancement) is unclear about what happens when a plan owner doesn't specify who the beneficiary is.

Read more: Why some heirs may face a tighter deadline to drain inherited IRAs

Backdoor Roths are still in play

Backdoor Roth conversions, a workhorse investing strategy of the ultrarich, are still an option, as legislation aimed at curbing them has stalled and the midterm elections render major tax changes unlikely in the near term. The strategy involves morphing a traditional individual retirement plan into a tax-free Roth, with the owner paying the tax bill upfront, the account growing over time and withdrawals tax-free. It's a way for wealthy people to sidestep the relatively low income limits for direct contributions to a Roth — and how PayPal co-founder Peter Thiel turned less than $2,000 worth of pre-IPO shares into a $5 billion account.

"Given that backdoor Roths are one of the few mechanisms that higher-income heavy savers can use to achieve tax-free withdrawals and avoid RMDs in retirement, many such savers are apt to conclude that it's a risk worth taking," said Christine Benz, Morningstar's director of personal finance, in a note earlier this year.

Read more: Roth conversion? Why to gamble on one this tax filing season