Regulations For Inheriting An IRA

 

As members of the greatest generation gradually pass, trillions of dollars of wealth are being transferred to their children and grandchildren. Much of this wealth resides in retirement accounts. These inherited retirement plans provide great benefits to beneficiaries. Over the past few years, legislation has been passed that shortens the lifespan for many of these accounts resulting in the reduction of benefits.

Prior to 2020, distribution options available to beneficiaries were simple and direct. Non spouse beneficiaries could either distribute the entire account and pay taxes or establish an Inherited IRA while spouses shared these same options but were also able to register the account as their own IRA. The choice of an Inherited IRA would result in the commencement of annual Required Minimum Distributions (RMDs) for the beneficiary over their lifetime but would allow the remainder of the account to remain intact and continue to benefit from tax deferral. The term “Stretch IRA” was coined since the assets and distributions could be stretched over the life of the beneficiary.

Enacted in 2019 and effective beginning in 2020, The Secure Act divided beneficiaries into two categories – Eligible Designated Beneficiaries (EDB) and Non-Eligible Designated Beneficiaries (NEDB). The old pre Secure Act stretch rules for designated beneficiaries continue to apply to the newly created EDBs. However, NEDBs are subject to a new 10-year rule. Under this rule, Inherited IRAs for NEDBs must be depleted by the end of the 10th year following the death of the decedent.

Eligible Designated Beneficiaries                                                              Non-Eligible Designated Beneficiaries
- Spouses
- Minor Children of the decedent                                                              - Non spouses
- Disabled persons                                                                                          - Certain trusts
- Chronically ill
- Not more than 10 years younger
- Certain trusts

The one caveat for EDBs is that minor children of the deceased can stretch the Inherited IRA until they reach the age of majority (age 18 or 21 depending on the state) at which time it triggers the beginning of the 10-year rule. Meanwhile, spouses remain the only beneficiary who can roll the deceased’s retirement account into their own and benefit by deferring RMDs until they reach age 73. If they choose to establish an Inherited IRA, they do not need to take the RMDs until the year the deceased would have attained age 73. The advantage is that they can begin distributions prior to age
59½ without incurring the 10% early withdrawal penalty.

The vague regulations under the Secure Act for annual RMDs for NEDBs during the 10-year time limit resulted in great uncertainty. As a result, many NEDBs were unaware that they were subject to RMDs and failed to take them in both 2021 and 2022. Earlier this year, there was clarification that if a deceased account holder was subject to RMDs prior to their death, the NEDB must continue them based on the longer of their own life expectancy or that of the account holder. If the account holder died prior to the onset of RMDs, the NEDBs could avoid annual distributions.

In response to the confusion, the IRS has proposed modifications that postpone RMDs through 2023 and waive penalties for distributions that were supposed to have been taken in 2021 and 2022. It is anticipated that the IRS will pass these revised regulations as early as 2024 but it is still unclear. Among the clarifications, it is likely that RMDs would need to begin in 2024. The penalty for missing an RMD is 25% of the amount that was required to have been withdrawn.

Finally, the regulations for Inherited Roth IRAs are much less complicated. Since RMDs are not required for Roth IRAs, a beneficiary can wait until the 10th year to liquidate the entire account tax free. However, there is one factor to consider if a beneficiary plans on taking distributions within 5 years. Distribution of gains on contributions that occur within 5 years of the death of the accountholder are subject to taxes. Beneficiaries should ensure that this time period has elapsed in order to avoid taxes if they wish to make a fully tax-free distribution.

The Secure Act was hastily passed with nebulous language that required interpretation for some provisions, particularly distributions for Inherited IRAs. While Secure Act 2.0 addressed some of the issues that needed to be amended, it did not provide clarification for RMDs for Inherited IRAs. This was left to the IRS which has issued proposals to eliminate this uncertainty. Given the size of distributions for many of these retirement accounts, beneficiaries should carefully plan to maximize benefits and minimize taxes.

Sincerely,

 

Clifford L. Caplan, CFP®, AIF®