After much anticipation, the Treasury Department and the Internal Revenue Service (IRS) have issued final regulations on the 10-year minimum distribution (RMD) rule for individuals who inherit assets from individual retirement accounts (IRAs).
The newly released guidelines generally reflect the IRS’s proposals for 2022, but provide clarity on several key issues regarding the rule that requires certain beneficiaries of retirement accounts to fully close out those accounts within a decade of the original account holder’s death.
Regulators have confirmed that most beneficiaries will continue to take RMDs annually during the 10 years and must fully liquidate the account by the end of year 10. However, as with any tax law change, there are exceptions and nuances in the rules that can cause confusion.
Background information on the new rule
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 introduced several significant changes related to retirement account RMDs. Additional RMD changes were made in the SECURE 2.0 Act of 2022. These changes impact not only account holder RMDs, but also retirement account beneficiary RMDs.
Before 2020, named beneficiaries who inherited IRAs, 401(k)s and other tax-free contribution plans could withdraw the funds over their lifetime. This allowed for smaller, longer distributions, as well as less taxable income and more time to accumulate gains. It was the basis of the so-called “stretch IRA,” an estate planning strategy often used with traditional IRAs.
Congress viewed this strategy as a loophole and restricted it in the SECURE Act for most non-spouse beneficiaries.
Under the SECURE Act, the general rule is that funds from an inherited retirement account transferred to a designated beneficiary must be paid out within 10 years of the original account holder’s death. However, there are several exceptions to the 10-year rule. It does not apply to:
- A surviving spouse
- Minor children of the original account holder who have not yet reached the age of 21
- Someone who is disabled or chronically ill (as defined in the regulations)
- A person who is not more than 10 years younger than the account holder
- An unnamed beneficiary, such as a charity, estate, or non-transparent trust
- Accounts acquired before 2020
Eligible beneficiaries who may apply for a lifetime extension are the above-mentioned spouse, minor child, or a disabled or chronically ill person who is no more than 10 years older than the account holder.
However, the original language of the law was not clear whether typical beneficiaries had to take RMDs over a ten-year period or whether they could wait until the tenth year to withdraw the full amount.
The IRS issued proposed regulations in 2022 that would require beneficiaries to take RMDs in years 1 through 9 if the original account owner died after reaching their RMD date. This led to confusion among beneficiaries who didn’t know whether they had to take RMDs from an account inherited from someone who died in 2020 or 2021 — or whether they faced a penalty if they didn’t.
Things got so confusing that, in response to public comments, the IRS postponed the RMD requirement and waived any penalties for failure to take RMDs from inherited accounts for 2021, 2022, 2023, and 2024. With the release of its final regulations, the IRS has finally clarified the matter.
Key takeaways from the final 10-year rule for IRAs
The final regulations will be published on July 19, 2024, will be 260 pages long and will explain in detail how the 10-year rule for inherited retirement accounts works.
In a press release, the IRS explains that the final regulations generally follow the proposed regulations beginning in 2022.
Crucially, the final rules answer one of the key questions people have been asking about the 10-year rule: Are annual RMDs required during the 10-year withdrawal period, or must the account simply be fully withdrawn within 10 years?
The answer has two parts and depends on whether the account holder died before or after the RMD start date:
- If the original owner dies before the RMD start dateBeneficiaries (who are not eligible named beneficiaries) do not have to take annual RMDs. They can choose to wait until year 10 to withdraw the money, take annual distributions, or skip years as long as the IRA is completely emptied by the end of the 10-year period.
- If the original owner died on or after the RMD start dateRMDs must be paid to the beneficiary over the 10-year period, beginning in the year after the owner’s death. Beneficiary RMDs are required in years 1 – 9, and the remainder of the account must be emptied by year 10.
Due to a series of IRS notices that extended beneficiaries’ RMDs from 2021 to 2024, the 10-year rule will not take effect until 2025.. But as mentioned, if the original account holder has already started taking RMDs, all of the money must be withdrawn from the account within the 10-year window, regardless of the specifics.
For example, if a named beneficiary inherits an IRA in 2021 from someone who began their own RMDs, the beneficiary would not have to take RMDs in 2022, 2023, or 2024. However, they would then have to take RMDs from 2025 to 2030, and by 2031 the account would have to be empty.
Ben Henry-Moreland, a senior financial planner at Kitces.com, wrote in a LinkedIn post that the IRS guidelines contain “a LOT of new rules” but nothing that is “groundbreaking from a planning perspective.”
He added, however, that the new rules make managing retirement accounts “even more and more incredibly complicated.”
One example of how the new rule complicates things: Spousal beneficiaries now have three different options for dealing with their deceased spouse’s retirement account—each with its own RMD calculation and associated advantages and disadvantages.
Henry-Moreland’s colleague Jeff Levine called the more clearly worded RMD regime “crazy” and particularly highlighted the “insanely complicated” family tree of beneficiaries that results from the new rules.
Tax and estate planning strategies for inherited retirement accounts
Despite these complications, there are some benefits for taxpayers in the final rule.
A “big win,” Levine said, is that the separate account rules for inherited IRAs now apply to trusts as well. This means that, in practice, a single trust can be named on the account beneficiary form along with other beneficiaries, such as a spouse and an adult child.
If the trust is immediately divided into subtrusts, each beneficiary of the subtrust can apply his or her own RMD rules after death. This also applies to all other beneficiaries.
Levine also describes a benefit related to transparent trusts that provides incentives for transferring funds from an eligible retirement plan, such as a 401(k), into an IRA.
Another trust strategy that can optimize the 10-year rule for inherited IRAs is to name a Charitable Remainder Trust as the beneficiary of an IRA. The term of the trust can be longer than the 10-year rule and allow the beneficiary to extend the tax benefits beyond a decade. Talk to your estate planning attorney to understand the pros and cons.
Other points to consider when developing an estate planning strategy with the new rules for inherited IRAs include:
- Beneficiary spouses have the option to treat the IRA as their own. If a spouse inherits a traditional IRA and the deceased spouse did not take RMDs, the surviving spouse can wait until they reach their RMD age before beginning withdrawals.
- Surviving spouses have the most flexibility regarding permissible distributions, but eligible named beneficiaries may also receive distributions over the course of their lifetime.
- The ability of disabled and chronically ill beneficiaries to maintain their retirement savings for life (which is not possible for regular beneficiaries) provides an opportunity to prioritize retirement accounts for individuals with special needs who can receive favorable tax treatment.
- The RMD is based on the beneficiary’s age. That is, the younger the beneficiary, the lower the annual RMD amount, although they can also choose to take larger withdrawals.
- All beneficiaries have the opportunity to make a lump sum payment from an inherited retirement account.
- Regardless of who inherits the IRA, the heir must receive the RMD for the year in which the account owner died by December 31. However, if there are multiple beneficiaries, the new rules allow the beneficiaries to divide the RMD for the year of death among the beneficiaries in any amount they choose. It no longer has to be divided proportionally according to the amount each person inherits.
- Withdrawals from retirement accounts are generally treated as taxable income, so beneficiaries should think about how much they want to withdraw each year. It may make more sense to withdraw in equal installments over 10 years rather than withdrawing the entire amount in year 10.
- Beneficiaries who do not take RMD face a penalty of 25 percent.
- Once a minor beneficiary reaches the age of 21, he or she is subject to the 10-year rule.
- Beneficiaries of a Roth IRA are not required to take annual RMDs for 10 years, and distributions are generally not taxed for Roth beneficiaries.
- A beneficiary may disclaim all or part of the inherited assets, which then pass to the next eligible beneficiary.
Original account owners and account heirs should talk to an advisor about how to manage distributions so they keep more of the proceeds and pay less in taxes. If you have questions about RMDs, how they affect you, and specific estate planning strategies for the 10-year rule, contact a local estate planning attorney.
Date created: 22.08.2024
