Many owners of inherited IRAs are in for a surprise. In a change, the Treasury Department reinstated required annual minimum distributions for most people who recently inherited Individual Retirement Accounts, according to proposed regulations released late last month interpreting the 2019 retirement law known as SECURE Law. IRA experts are still reviewing the 275 pages.
What we know so far is this: If you inherited a traditional IRA or 401(k) in 2020 or later, be careful because the rules have changed — again.
“The IRS is interpreting the SECURE Act's 10-year rule differently than everyone thought,” says Ed Slott, a CPA and IRA expert in Rockville Centre, NY.
Under the new regulations, if you inherited a traditional IRA from someone who was past the required starting date and had been taking payments (required minimum distributions/RMDs), you can't wait until year 10 to take the money out. Instead, you must take annual distributions in years 1 through 9 and the balance in year 10. That could wreak havoc on your taxes.
Slott says he got a call from an advisor with a client who inherited a multimillion-dollar IRA in 2020. Should the client go back now and take out a $250,000 payment for 2021 that he just found out this week was missed? Technically, yes, you had an RMD in 2021. RMDs for traditional IRA heirs start the year after the IRA owner dies. You would need to double up and take two payments in 2022 and file a Form 5329 to waive the 50% penalty. Or it could wait and see if the final regulations include relief for people who inherited IRAs in 2020, Slott says.
What if Grandma dies in 2021 and leaves an IRA to her daughter, age 60, and a Roth IRA to her grandkids? The daughter might have thought she could stop taking RMDs, and the accompanying tax bite, until she retired, but under the new rules, she'll have to start taking RMDs this year, which will increase her tax bill. The grandchildren are luckier. Because Roth IRAs don't have RMDs, grandchildren can keep their inherited Roth IRAs intact until year 10, when they have to withdraw all the money.
The backstory here is that it used to be that you could name a non-spouse beneficiary, say your daughter, to inherit your IRA, and when you died, she could keep the IRA for life, taking the minimum payments. requirements established by the Internal Revenue Service each year. It was known as an extended IRA: payments could be spread out over years. That tax deferral for potentially decades was worth a lot. But the stretch was too good to be true. In the SECURE Act, Congress eliminated the tranche of inherited IRAs for deaths starting in 2020, as an increase in income: Payments from traditional IRAs are taxable income, so the Treasury would receive its taxes sooner.
Congress left the stretch rule for some special "eligible" beneficiaries, for example, people with disabilities or close in age to the deceased. They could still stretch the payments out over your lifetime. But he put a new 10-year rule in place of the bracket for everyone else. Most experts thought annual payments would not be necessary under the new 10-year rule. In March 2021, the IRS revised Publication 590-B (IRA Distributions), hinting that it would require annual RMDs to be paid in years 1 through 9 and any remaining IRA funds to be paid in year 10. In a revision In May 2021, the IRS made it clear that annual RMDs were not required under the 10-year rule after all.
Now, with the proposed rules, the IRS has returned to its previous position. That's putting people who recently inherited IRAs in a bind. First, how many of them get annual advice from a tax expert to find out the rules have changed, again? If they fail to make the required payments, there is a stiff 50% penalty on the amount that should have been withdrawn.
"It's just another place where people can make mistakes," says Slott.
In practice, in many cases, it's probably wise for some heirs to take more than the required payments in years 1 through 9, so they don't get swamped in year 10 with a large tax bill. But the previous interpretation of the 10-year rule, in which you could take money out in any year you wanted, gave heirs the most flexibility. Depending on their tax situation, that gave them the option of taking out more money in one year and nothing in another, or alternatively leaving all the money in the account tax-free for 10 years.
If you're a 2020 or later heir, IRA expert Denise Appleby says she recommends waiting until near the end of the year before taking 2021 or 2022 RMDSs. By then, the IRS will likely have issued either final RMDS regulations. RMDs, or notices and other guidance removing the rules and stating whether there is any blanket reprieve for those who didn't take payee RMDs, because IRS Publication 590-B said they did. I do not have to.
Commentators are already weighing in. Some say the IRS is dead wrong: "These rules are contrary to statute as well as prior final regulations." Others are calling for relief: "If the current proposed regulations are enacted, at a minimum, a safe harbor exception should be included." There's a lot more to the new regulations: a new definition of minor (21 years old, even if your state says 18 years old) and new rules for IRAs held in trusts. The Treasury Department is accepting comments through May 25, 2022.