A few years ago, if you inherited an IRA from a parent, the rules were straightforward: you could spread out withdrawals over your lifetime. But since then, the rules for non-spouses inheriting retirement accounts have become more complicated. Starting in 2020, most new beneficiaries had to follow a 10-year rule. This was generally understood to mean that required minimum distributions (RMDs) were no longer necessary, and beneficiaries had to withdraw the entire amount within 10 years. However, in early 2022, the IRS proposed changes that would require some beneficiaries to take RMDs and empty the account within 10 years. A final decision is still pending, and the IRS has waived penalties for certain beneficiaries through 2024.
This news should be a relief for many. If you haven’t yet considered planning strategies for inherited IRA distributions, now is the time.
In April 2024, the IRS released Notice 2024-35, waiving penalties for certain beneficiaries of inherited retirement accounts who missed RMDs in 2024, as required under the 2022 proposed guidance. Since this can be confusing, let’s start from the beginning.
The ‘stretch IRA’ used to be a common option. Most non-spouse beneficiaries who inherited any type of IRA or a defined contribution plan like a 401(k) or 403(b) could choose to withdraw the funds by taking RMDs over their lifetime. Beneficiaries would calculate their life expectancy based on their current age using the IRS’ uniform lifetime table.
It’s important to note that the Secure Act or any subsequent changes do not affect beneficiaries who inherited a retirement account before 2020. These individuals can continue to stretch distributions over their lifetime.
The Secure Act created two classes of designated non-spouse beneficiaries: eligible designated beneficiaries (not subject to the 10-year rule) and non-eligible designated beneficiaries. This article focuses on the distribution rules for non-eligible designated beneficiaries, as they are more common.
Initially, it was assumed that when a decedent died after January 1, 2020, a non-spouse beneficiary (non-eligible designated beneficiary) had to empty the retirement account by the end of the 10th year following the year of death, with no RMDs required.
For reference, a non-spouse eligible designated beneficiary includes minor children of the account owner until age 21, disabled or chronically ill individuals, and individuals not more than 10 years younger than the account owner.
In early 2022, the IRS issued proposed guidance that surprised the financial community. The changes would require non-eligible designated beneficiaries to take distributions in years one through nine and withdraw all the funds in year 10, but only if the decedent was subject to RMDs when they died. Distributions during the 10-year window would generally be based on the beneficiary’s own single life expectancy according to the IRS’ Uniform Lifetime Table, reduced by one each year.
The IRS released Notice 2022-53, announcing that final regulations would be forthcoming and would apply (at the earliest) to the 2023 distribution year. Individuals affected by the new rules who missed RMDs in 2021 and 2022 would not be subject to ordinary penalties. The penalty waiver extends to 2023 for those who may be affected by the still-pending guidance. Starting in 2023, the penalty for a missed RMD is 25%, down from 50% before 2023. The IRS expects to release final guidance in 2024, with the penalty waiver extending to 2024 for those affected by the pending guidance.
If you are the executor of a parent’s estate, consider planning strategies to mitigate the tax impact of inherited IRA distributions. Pre-tax contributions to an IRA, 401(k), or 403(b) will be fully taxable to the beneficiary as regular income once distributed. Some heirs may face significant changes to their tax situation if forced to take a large distribution from an inherited retirement account. The delay offers more time to consider various planning strategies.
If you’ve inherited a retirement account from a parent or relative, consider working with your financial and tax advisor to assess your situation and stay informed about upcoming changes.