IRS Throws IRA Beneficiaries a Curve Ball
In December 2019, Congress passed the SECURE Act, which included significant changes to the Individual Retirement Accounts (IRAs) rules. Among these was an increase in the Required Minimum Distribution (RMD) age from 70.5 to 72. Another critical change curtailed “stretch” IRA distributions, whereby IRA beneficiaries were allowed to calculate RMDs based on their life expectancy, potentially spreading the tax consequences over decades. Instead, the IRS instituted a new “10 Year Rule,” which—with a few exceptions—required non-spouse IRA beneficiaries to entirely distribute an inherited IRA within ten years of the date of death of the original owner (a.k.a. the decedent).
We wrote about these changes in a contemporaneous blog post. Back then, the consensus understanding of the law within the financial community was that IRA beneficiaries would have discretion over the timing of their withdrawals from an Inherited IRA, so long as they met the requirement to fully distribute the account by December 31 of the tenth year following the original account owner’s death.
In 2021, the IRS issued updated guidance on the 10-Year rule, which essentially reinforced this interpretation (emphasis added):
The 10-year rule requires the IRA beneficiaries who are not taking life expectancy payments to withdraw the entire balance of the IRA by December 31 of the year containing the 10th anniversary of the owner’s death. For example, if the owner died in 2021, the beneficiary would have to fully distribute the IRA by December 31, 2031. The beneficiary is allowed, but not required, to take distributions prior to that date.
However, in February of this year, the IRS proposed a different interpretation of the rule (yet to be finalized) which would substantially reduce flexibility for some beneficiaries. Specifically, the IRS aims to distinguish between decedents who died on or after reaching RMD age, with those who had not yet reached their beginning age for RMDs.
Under the proposed guidance, beneficiaries of decedents who had reached RMD age would be required to make their own RMDs (using the old “stretch” IRA calculations) in years 1 through 9 following the account holder’s death and distribute the remaining balance in year 10. Beneficiaries of a decedent who had not yet reached RMD age would retain discretion over the timing of their distributions, so long as they deplete the inherited IRA by the end of the tenth year.
This rule would substantially constrain tax planning flexibility for most non-spouse beneficiaries if adopted as proposed. In theory, beneficiaries who inherited an IRA in 2020 but did not take an RMD in 2021 could be subject to a 50% penalty on that RMD amount. However, since this new IRS guidance comes more than two years after the original SECURE Act passed, it seems likely that penalties would be waived (or that the rule would take effect prospectively, i.e., for IRAs inherited in 2022 and later). Still, it appears that the IRS interprets the 10-Year rule more narrowly than indicated when the SECURE Act first passed, and IRA beneficiaries should revise their tax planning accordingly.
One other item of note: since Roth IRAs are not subject to RMDs at all, neither are beneficiaries of Roth IRAs required to make interim RMDs—they can wait and take a lump sum distribution of the entire inherited IRA balance at the end of year 10, all of it tax-free. This comparative tax efficiency bolsters the case for Roth IRA conversions, particularly for investors intent on leaving a financial legacy to heirs.
If you recently inherited an IRA and are still confused about how these changing regulations might impact you, please feel free to reach out to your advisor or schedule a free appointment with one of our principals.
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