A lot of inherited IRA owners are in for a surprise. In a switcheroo, the Treasury Department has reinstated annual required minimum distributions for most folks who’ve recently inherited Individual Retirement Accounts, according to proposed regulations released late last month that interpret the 2019 retirement law known as the SECURE Act. IRA experts are still poring through the 275 pages.
What we know so far is this: If you inherited a traditional IRA or 401(k) account in 2020 or later, watch out because the rules have changed—again.
“The IRS is interpreting the SECURE Act’s 10-year rule differently than what everybody thought,” says Ed Slott, a CPA and IRA expert in Rockville Centre, N.Y.
Under the new regulations, if you inherited a traditional IRA from someone who had already passed their required beginning date and had been taking out payments (required minimum distributions/RMDs), you can’t wait until year 10 to take out the money. Instead, you have to take annual distributions in years 1 to 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 he missed? Technically, yes, he had an RMD in 2021. RMDs for inheritors of traditional IRAs start the year after the IRA owner’s death. He should double up and take two payments in 2022 and file a Form 5329 to waive the 50% penalty. Or he could wait it out, and see if the final regulations include relief for people who inherited IRAs in 2020, Slott says.
What if grandma died in 2021 and left an IRA to her daughter, age 60, and Roth IRAs to her grandkids? The daughter might have thought she could hold off on taking RMDs—and the tax bite that goes along with them—until she retired, but under the new rules, she’ll have to start taking RMDs this year—increasing her tax bill. The grandkids are luckier. Because Roth IRAs don’t have RMDs, the grandkids can keep their inherited Roth IRAs intact until year 10 when they have to take all the money out.
The back story 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 her lifetime, taking required minimum payments set by the Internal Revenue Service each year. It was known as a stretch-IRA—payments could be stretched out for years. That tax deferral over potentially decades was worth a lot. But the stretch was too good to be true. In the SECURE Act, Congress eliminated the stretch for inherited IRAs from deaths starting in 2020, as a revenue raiser: Payments from traditional IRAs are taxable income, so the Treasury would get its taxes sooner.
Congress left the stretch rule in place for some special “eligible” beneficiaries—folks with disabilities or close in age to the decedent, for example. They would still get to stretch payments over their lifetimes. But it put a new 10-year rule in place of the stretch for everyone else. Most experts thought that annual payments wouldn’t be required under the new 10-year rule. In March 2021, the IRS revised Publication 590-B (Distributions from IRAs), hinting that it would require annual RMDs to be paid in years 1-9 and the remaining IRA funds to be paid out in year 10. In a revision in May 2021, the IRS made clear that annual RMDs weren’t required under the 10-year rule, after all.
Now, with the proposed regs, the IRS has flip-flopped back to its earlier position. That’s putting folks who inherited IRAs recently in a bind. First, how many of them are getting annual advice from a tax expert to know that the rules have changed—again? If they fail to take out the required payments, there’s a harsh 50% penalty on the amount that should have been withdrawn.
“It’s just another place where people can make mistakes,” Slott says.
In practice, in many cases, it will probably be smart for some heirs to take more than the required payments in years 1 to 9, so they don’t get hammered in year 10 with a big tax bill. But the earlier 10-year rule interpretation—where you could take money out in any year you want—gave heirs the most flexibility. Depending on their tax situation, that gave them the option to take out more money in one year and none in another, or alternatively to leave all the money in the account growing tax-free for 10 years.
If you’re a 2020 or later inheritor, IRA expert Denise Appleby says she recommends waiting until close to the end of the year before taking 2021 or 2022 RMDS. By then, the IRS will likely have issued either final RMD regulations or notices and other guidance that flushes out the rules and state whether there is any blanket reprieve for those who did not take beneficiary RMDs because IRS Publication 590-B said they did not have to.
Commenters are already chiming in. Some say the IRS is just flat out wrong: “These rules are contrary to the statute, as well as prior final regulations.” Others are asking for relief: “If the current proposed regulations are enacted, at a minimum, a safe harbor exception should be included.” There’s a lot more in the new regulations: a new definition of a minor (age 21 even if your state says age 18) and new rules for IRAs left to trusts. The Treasury Department is accepting comments through May 25, 2022.