Provident Investment Management
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News & Insights

 

An Update on Inherited IRAs

 

The SECURE Act and SECURE 2.0 Act introduced a number of changes related to IRAs, some favorable and some unfavorable. One of the unfavorable changes was the introduction of the “10-year rule,” where traditional and Roth IRAs inherited by non-spouse beneficiaries (with certain exceptions for eligible designated beneficiaries) had to be emptied by the tenth calendar year following the IRA owner’s death. Previously, non-spouse beneficiaries could stretch out the distributions over their own life expectancies, resulting in smaller required payouts and greater potential for tax-advantaged growth. Congress felt this was too big of a break for beneficiaries and needed to offset the funds lost from delaying required minimum distributions (RMDs), which led to the rule change. Spouses, along with certain other eligible designated beneficiaries were able to continue taking distributions from inherited IRAs over their own life expectancies, but this change meant most beneficiaries were now forced to take distributions sooner.  

The 10-year rule as initially outlined left some room for interpretation, and there was some confusion whether those who inherited an IRA must take minimum withdrawals each year or if they could wait until the final year to fully distribute the funds in the account. This topic was covered in a Viewpoint in 2022, as the IRS had proposed a rule requiring annual minimum distributions during the 10 years. Investors pushed back against this proposal, but the purpose of this Viewpoint is to highlight that the Internal Revenue Service recently issued long-awaited final regulations specifying the annual distribution requirement for many inherited IRAs. Even these final rules, however, may be impacted by public criticism of the rules and the outcome of the November elections. 

For those who have inherited IRAs since 2020 but have not taken what would have otherwise been required distributions under the final regulations, there are no penalties through 2024 nor are beneficiaries required to make up for missed payments. However, beginning in 2025 the penalty for missed withdrawals is 25% of the required withdrawal amount. 

Under the newly finalized rules, a key point of determination is if the individual who died had already reached the beginning date for taking required minimum distributions (RMDs). Currently RMDs must be taken when you turn 73 (increased from 72 in 2023). If the decedent had reached the date for taking RMDs, the individual who inherits the account must take annual payouts beginning in the year after the individual dies. Required annual payouts are based on the life expectancy of the beneficiary, while the entire account balance still must be distributed by the end of the 10-year period.    

If the owner of the IRA dies before they are required to take RMDs, the beneficiary is not subject to an annual withdrawal requirement; however, the account must be fully distributed by the end of the 10-year period. This offers greater flexibility as the beneficiary could delay taking distributions until funds are needed, such as for the beneficiary’s own retirement.  

Based on the beneficiary’s tax circumstances, it may make sense to withdraw more than the required annual amount over the 10-year period to avoid a balloon payout in year ten, when the account must be fully emptied. A sizable lump sum payment in the final year could result in a large tax bill if the distribution moves the beneficiary into a higher income bracket. A discussion with your tax professional can help you be strategic with the timing and amount of your distributions, potentially taking larger distributions in lower-income years in order to minimize the tax impact. 

One fact that remains unchanged is that the Roth IRA remains the best IRA to inherit. Roth beneficiaries remain subject to the 10-year rule. However, there is no distribution requirement until the 10th year, and withdrawals are generally tax-free. Because of this, it typically makes sense to allow an inherited Roth IRA to grow for as long as possible to maximize the potential for these inherited funds. 

As noted above, there remain five classes of eligible designated beneficiaries who are not subject to the 10-year rule and can continue to benefit from the legacy stretch rules allowing for the distribution of the inherited IRA over their expected lifetimes. The first of the five is spouses. The second class is minor children —note this does not include grandchildren. Also, minor children who have inherited IRAs are subject to the stretch rules only until age 21, at which point they become subject to the 10-year rule. The third and fourth classifications include individuals who are disabled or chronically ill, both of which are subject to strict definitions. The final classification is individuals who are not more than 10 years younger than the decedent. The inclusion of this last group is a bit of an odd quirk that was presumably allowed because the beneficiary is close in age to the decedent. It po­tentially opens some tax planning opportunities, where distributions from the inherited IRA could be used to fund gifts to relatives of the decedent.  

The IRS has made inherited IRAs quite complex by layering rules upon rules (i.e., rules for inherited IRAs pre-2020, the implementation of the 10-year rule, new distribution rules dependent upon whether the decedent was subject to RMDs, etc.). For our clients, we are encouraging a wait-and-see approach as it relates to the recently issued final regulations, as they are not set to go into effect until 2025. We anticipate there is likely to be continued pushback against the new rules, and the outcome of the election in November is another factor that could potentially impact their ultimate implementation. Given the potential impact on many of our clients, we will continue to monitor future developments and keep you updated. As always, if you have any questions, please reach out and we will do our best to answer them.

James Skubik, CFA