After many years of confusion, the IRS has finally clarified the rules around Inherited IRA’s. Under the old rules when a non-spouse inherited an IRA, the beneficiary was required to take a distribution every year based upon their life expectancy. As a result of the SECURE ACT 1.0, which took effect in 2020, several rules for retirement accounts changed. Among these were changing the required distribution age, establishing categories of beneficiaries such as an eligibledesignated beneficiary and non-eligible beneficiary, and changing the length of time required to deplete an account via required distributions.
Originally, Inherited IRAs were subject to a mandatory distribution based upon the life expectancy of the Inheritor. Secure Act 1.0 changed the distribution rules for non-eligible designatedbeneficiaries from a life expectancy withdrawal to having to withdraw the entire IRA balance by the 10th year after the passing of the original account holder. Non-eligible designated beneficiaries are most non-spouse beneficiaries, and some see through trusts.
An eligible designated beneficiary is a surviving spouse, a disabled or chronically ill person, person’s less than 10 years younger than the decedent, minor children and some see through trusts. Eligible designated beneficiaries have the option to stretch the IRA distribution over their lifetimes. The exception is when a minor child attains the age of majority, at which time the distribution schedule switches to the same 10-year rule.
The area under the new rules that left some ambiguity was whether a non-eligible designatedbeneficiary had to take at least some portion of the distribution annually. Over the last few years, the IRS waived the required distribution for non-eligible designated beneficiaries even when the decedent had already reached their required minimum distribution age prior to passing away. Whether the decedent had already begun taking their required distribution or not, the IRA account still needed to be withdrawn by the tenth year after the passing of the decedent.
The IRS finally clarified the rule, whereby a non-eligible designated beneficiary subject to the ten-year rule must take a required distribution each year. The account must be fully withdrawn by the end of the tenth year. This is true regardless of whether or not the decedent had reached the age of required distributions prior to passing away. What still has not been clarified is the amount of the annual distribution each year. While you must take withdrawals in each of the 10-years following the passing of the decedent, is there a minimum annual amount? At this point, that remains somewhat a question. It seems that they are implying that a minimum distribution each year must be taken equal to the life expectancy tables of the beneficiary. However, if only the minimum life expectancy withdrawal is met in the first 9 years, that would leave a sizeable lump sum in the 10th year.
As a result, some financial planning is still required, as you might have to take a rather large distribution in the 10th year if you haven’t taken relatively equitable withdrawals in the first 9 years. In many cases it may be wise to take distributions equally that are close to 1/10th of the account balance per year in order to spread out the tax liability until further clarity on the rules exists. To avoid an adverse taxable event, it would be prudent to plan so that you’re not surprised by a rather large tax bill in a single year. As always, talk with your tax advisor or financial professional to determine the best course of action.
It is also important to note, these rules do not take effect until January 1st of 2025.
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Fixed income as an asset class should always be a fixture to some extent in any well-constructed asset allocation strategy. However, investing in fixed income is not without its own risks. Bonds can pose various risks. Among them are:
Credit Risk – The risk of the issuer defaulting.
Interest Rate Risk – The risk of rates rising after you’ve purchased a bond.
Inflation Risk – The loss of purchasing power more than the interest you are earning on a bond.
Liquidity Risk – The devaluation of a bond due to the lack of demand from a shock to the financial system.
Investing in an individual bond as opposed to a diversified bond portfolio can substantively increase these risks. The bond market in most years has been a more stable asset class than the stock market, yet with lower historical returns. This is because as a bond owner you are a lender of cash to a corporation or government agency rather than a stockholder in a potentially growing business.
As a comparison, the S&P 500Index has been positive approximately 75% of the time, whereas the Barclays Aggregate Bond Index has been positive 92% of the time. Historically speaking, a bad year for bonds was in the vicinity of a -2% decline. A very bad year would be a -5% decline. However, in 2022 the Barclays Aggregate Bond Index declined by -13%, which was the worst decline in more than 200 years.
This decline was due to the unprecedented speed at which the Federal Reserve increased the Fed Funds rate to combat inflation. Interest rates climbed from near zero, to what is now 5.50%. While a 5.50% Fed Funds rate is not unprecedented, such a fast increase was a shock to the financial system after nearly two decades of close to zero interest rates.
As with any significant decline, this can create opportunities. As a result, it appears that there are many areas of opportunity in the current bond market. Many areas in fixed income are still trading below their par value, which is the value at which a bond will mature at. This means you can buy many bonds at a discount to maturity, plus collect the cash flow of interest payments. Many fixed-income managers see this as a great opportunity.
Additionally, the opportunity may be due to the anticipated next move of the Federal Reserve. While we can never be certain of their next policy move, fixed income managers will tend to position themselves around such expectations. They examine the economic environment and anticipate what the Federal Reserve response is likely to be. Again, there is no guarantee they will be right. Let us remember that in 2021 the Federal Reserve was calling inflation “transitory” and saw no need for concern. Not long after they realized they were wrong and began an unprecedented policy shift.
In looking at the current economic landscape, it seems unlikely the Federal Reserve will be raising rates again any time soon. The probability of a rate cut is much higher in the short term. How much of a cut and precisely when is difficult to predict. This depends heavily on the degree of economic slowdown or recession that is approaching.
What we do have is some historical context around how bonds behave when the Federal Reserve stops increasing rates, as well as how bonds did when they first began to cut rates. What we can see from the above slide courtesy of Guggenheim Investments is the following:
In the 3-year period following the end of an increasing rate cycle, the average return of the Barclays Aggregate Bond Index is 7.5% per year.
In the 3-year period following the first rate cut, the average return of the Barclays Aggregate Bond Index is 4.7% per year.
What is interesting to note is that the 3-year returns are higher before the rate-cutting cycle begins. This may seem counterintuitive, as once the Fed actually cuts rates existing bonds should become more valuable. However, remember that financial markets are a discounting mechanism. What we are likely seeing in this data is that the marketplace had already begun to price in the decline in rates before they happened. This anticipation leads to bond buying, and increased prices.
This is another example of why market timing is so difficult, and why asset allocation and the exposure to all asset classes at all times is so important. However, this also tells us that at this moment in time, the bond market, which is coming off of an unusually bad period beginning in 2021 and culminated in 2022 is probably well positioned over the next few years. While we don’t encourage market timing, waiting to allocate the appropriate amount towards fixed income can be a costly mistake.
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