IRS Issues Final Rules for Inherited IRAs
After much anticipation, the Department of the Treasury and the Internal Revenue Service (IRS) issued their final rules on required minimum distribution (RMD) requirements for IRA beneficiaries.
On July 19, 2024, the IRS clarified that certain non-spouse IRA beneficiaries are in fact required to take annual RMDs from their inherited account each year and other beneficiaries are not. Although these rules can be complex, they generally follow the proposed rules that were issued in 2022.
Before diving into how these RMD rules work, it’s important to understand how this all came about in the first place. Back in 2019, the SECURE Act (Setting Every Community Up for Retirement Enhancement) passed into law and made a number of changes to retirement accounts, including distribution options available to beneficiaries who inherit an IRA on or after January 1, 2020.
Two of the most significant changes in the SECURE Act included:
1 – Elimination of the Stretch IRA
Prior to the SECURE Act, an individual who inherited a retirement account had the ability to stretch distributions from the account over their lifetime. Every year, a percentage of the account would need to be distributed, but the remaining balance could continue to grow tax-deferred or tax-free depending on the type of account. Since these accounts were allowed to grow for many years, they were used as a multi-generational legacy tool.
Congress intended for retirement accounts to primarily support an individual’s retirement, rather than serve as a legacy tool. As a result, they eliminated the stretch IRA for certain beneficiaries and introduced the new 10-year rule.
2 – Introduction of the 10-year rule
For most non-spouse beneficiaries, the SECURE Act now mandates that the entire account balance of an inherited IRA or qualified retirement plan be distributed by the end of the 10th year following the year of the account owner’s death.
When the SECURE Act first passed, many national experts interpreted it to mean that non-spouse beneficiaries would not need to take any RMDs, but that the account must be liquidated by the end of the 10th year.
However, when the IRS released its proposed regulations back in 2022, they interpreted the law quite differently. The IRS said that if an owner of a retirement account reached their required beginning date (which is April 1st of the year following the year in which they reach RMD age), then the beneficiary must continue to take annual RMDs for years 1-9 after death and the account must be liquidated by the end of the 10th year. These RMDs are to be calculated based on the beneficiary’s life expectancy.
The IRS surprised many experts with this interpretation, but this determination is in line with an existing tax rule known as the ‘at least as rapidly’ rule. This means that once RMDs are turned on for an account, they cannot be turned off. So, even though the beneficiary is now technically the account owner, they don’t have the ability to shut off these RMDs.
The IRS also clarified that beneficiaries who inherit a retirement account where the original account owner did not reach their required beginning date, those beneficiaries are not mandated to take any distributions from the account for years 1-9 after death, but they must still liquidate the account by the end of the 10th year. As Roth IRA owners are not subject to RMDs, these beneficiaries will fall under this rule.
Keep in mind, not all beneficiaries of an IRA are subject to the 10-year rule. Certain beneficiaries, known as “eligible designated beneficiaries,” are exempt from the 10-year rule. These beneficiaries include surviving spouses, minor children up until the age of 21, disabled or chronically ill individuals, and individuals not more than 10 years younger than the decedent. These beneficiaries are still allowed to take advantage of the stretch IRA and take distributions over their lifetimes.
Let’s look at a hypothetical example to help clarify these distribution requirements:
Steve, age 40, inherited a traditional IRA from his Uncle Mike, who was 78 when he passed away in 2024. As Steve does not meet one of the exceptions to be an “eligible designated beneficiary,” he is considered to be a “non-eligible designated beneficiary” and is therefore subject to the 10-year rule.
As Mike was 78 when he passed away and subject to RMDs, Steve will also be subject to RMDs during his 10-year window. This means that Steve will need to take a beneficiary RMD from the account for years 2025-2033, with a full liquidation of the account by 2034. These RMDs will be calculated based on Steve’s individual life expectancy.
If Uncle Mike was only 65 when he passed away or owned a Roth IRA, Steve would NOT be required to take RMDs for years 2025-2033 because Mike did not meet his “required beginning date,”, but Steve would still need to liquidate the account by the end of 2034.
The final regulations released by the IRS are effective on September 17, 2024, meaning that these rules will impact RMDs beginning in 2025. Due to the complexity of these rules, the IRS previously waived the penalties on missed RMDs for these beneficiaries for tax years 2020 through 2024.
The SECURE Act’s RMD rules for 10-year beneficiaries bring significant changes to how inherited retirement accounts are managed. Beneficiaries should take the time to understand these complex rules and work with a financial advisor to help make informed decisions that align with their long-term goals.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.
Joseph P. Marmorato
Private Client Group Planner
CPA