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Finally, after years of waiting and much confusion, the IRS and the Treasury Department have issued their much anticipated final regulations concerning distributions on inherited IRAs.
The SECURE Act of 2019 created the 10-year rule, requiring non eligible beneficiaries to deplete the entire inherited IRA within 10 years of the original owner’s death. Therefore, it was clear that under the new rules starting in 2020, the so-called “Stretch IRA,” a strategy allowing beneficiaries to stretch distributions out over the entirety of their own life, would be a thing of the past.
However, ever since the original SECURE Act was passed, advisors and tax professionals have been unsure of how exactly to interpret the distribution rules for inherited IRAs and specifically whether RMDs would be required as part of the 10-year rule.
On Thursday, the regulators confirmed that RMDs would also be required for most non-spouse beneficiaries in each of the 10 years after the account holder’s death. To be clear, the inherited IRA still must be completely drawn down by the end of the 10th year. So now, most non-spouse beneficiaries must take RMDs and make sure the account is $0 by the end of the 10th year.
Now that the regulators have issued their final interpretation of the 10-year rule, we explore five aspects of the new guidance that every advisor should understand.
By understanding the 10-year rule, you can work closely with clients to help them effectively navigate the complexities of inherited IRAs.
1. What is the new 10-year rule?
The IRS and Treasury Department clarified that beginning in 2025, someone who inherits an IRA account must take annual required minimum distributions (RMDs) from the IRA starting the year after the death of the original owner. This RMD is in addition to the existing 10-year rule that the entirety of the inherited IRA must be distributed by December 31 of the 10th year following the death of the original owner.
Since the IRS had not clarified the 10-year rule since the passing of the SECURE Act at the end of 2019, many inherited IRA beneficiaries have opted not to take annual distributions, since they were not specifically required. Instead, many beneficiaries instead planned to delay the total distribution until the 10th year.
Due to the confusion as to whether RMDs were required during the 10 years, the IRS essentially excused those missed years (2021–2024), and will not require the distributions to be made up. However, distributions must be taken starting in 2025, and the 10-year window is not being reset. Therefore, if a taxpayer received an inherited IRA in 2020, they must begin RMDs in 2025 AND the account must still be fully distributed by the end of 2030.
Important item to note: These final regulations only apply to a taxpayer’s inherited IRAs. Their personal IRAs do not become subject to these rules by association and they still fall under the normal rules for IRAs and RMDs.
2. These new rules only apply to non-spouse beneficiaries
The 10-year distribution rule (now including annual RMDs per the recent IRS guidance), is only for non-spouse beneficiaries, like children, siblings, friends, etc.
The rules surrounding distributions for IRAs inherited by spouses have not been affected, and are generally straightforward. As a reminder, the surviving spouse has several options. She can continue to receive distributions from the inherited IRA account (should she need to cover living expenses and if she is significantly younger), she can roll the IRA over to a new account in her name (and delay RMDs until she turns 73), or she can step into the shoes of the deceased under SECURE Act 2.0 and begin taking distributions when the deceased would have started.
3. The age of the deceased and whether they began distributions is an important factor
Another important consideration is the age of the deceased at the time of death.
Again, the final regulations only apply to non-spouse beneficiaries when the deceased was over the age of 73 and already taking RMDs at the time of death. When the decedent is under the age of 73 at the time of passing, then the beneficiary inherits the IRA and they are allowed to take the money out any time during the 10-year period, even waiting until year 10, according to the final rules.
4. Watch out for ballooning distributions—and big tax bills
While the IRS has clarified that RMDs must be taken from the inherited IRA, the distribution factors will not spread the distributions out proportionally across the 10-year distribution window.
This means that, depending on their age, if beneficiaries take only their required distributions every year, the bulk of the account will be largely intact after 10 years. Then in year 10, they may need to take a total distribution of the remaining balance, which could lead to a very much less-than-ideal tax hit!
Consider a scenario where a client is already earning a high income and then waits until the tenth year to take the final distribution. This combination could result in an enormous tax liability!
Therefore, it is extremely important to identify clients who have large inherited IRAs that are subject to this new rule and to be proactive. Consider this as an opportunity to provide planning for at least the next 10 years, optimizing distributions in a tax efficient manner each year based on the client’s income and the size of the inherited IRA.
You could be thinking about accelerating distributions in lower income years or pairing the distribution with charitable giving. Each year represents a new and different opportunity for what we refer to as “post-mortem” tax planning.
5. Be sure to avoid penalties
Given the confusion surrounding the requirements for inherited IRAs, it is important that clients be made aware of the need to take their annual RMDs. As a reminder, the penalty for missed RMDs is 25% of the total distribution amount.
As we navigate these new IRS guidelines for inherited IRAs, it is clear that proactive planning is more crucial than ever. The complexities of the 10-year rule, annual RMDs, and potential tax implications underscore the importance of staying informed and being strategic.
As an advisor, you should educate your clients on the final 10-year rule and take the initiative to help them optimize their inherited IRA strategy, whether that involves careful distribution planning, or exploring charitable giving options.
With this, each year presents a new opportunity for you to show your value and adapt as tax law evolves and your clients’ situations change.