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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Inheriting an IRA: a blessing and a potential curse

In response to the retirement savings deficit abroad in the nation, Congress passed legislation in late 2019 making significant changes to tax-deferred retirement savings plans like 401(k) and IRA accounts. The legislation, called the SECURE Act, added incentives, increased contribution limits, and delayed the date at which require minimum distributions must begin. A subsequent 2022 annex called SECEURE 2.0 further raised the age for minimum distributions to 73.

Among the myriad provision was a rework of the rules governing inherited IRA accounts which became effective on January 1, 2020, and confusion has reigned ever since. More than 3 ½ years later, ambiguities in the law and a torpid regulatory process have forced the IRS to issue provisionary guidance and temporary relief in the interim until final regulations are cemented, presumably by year end. If you inherited an IRA after 2019, you should seek professional advice to navigate the maze, here’s a brief look at the current state of play.

Prior to the SECURE Act, spouses could simply assume an inherited IRA as their own, while non-spousal beneficiaries had a couple of options. They could either deplete the account (and pay the taxes) any time over the next 5 years or spread out the distributions over their own lifetime. The latter adoption, dubbed a “stretch IRA”, allowed for the lightest tax treatment and greatest potential tax-deferred growth. SECURE put an end to the stretch except in the case of a spouse or a few other limited circumstances.

Additionally, the Act replaced the 5-year rule with a 10-year distribution timeframe for non-spousal beneficiaries, meaning that all the funds must be depleted and taxed by the end of the 10th year following the death of the original owner. Herein lies the rub and the source of the confusion: can the beneficiary wait until the 10th year and then take it all, or must they begin making annual distributions each year?

Since the old 5-year rule was clear that one could wait until the very end, tax consultants generally assumed the 10-year rule would operate the same way. Pro tip: make no assumptions where the tax code is concerned until the ink is dry. A proposed regulation from the IRS issued in 2022 dropped the hammer and required beneficiaries to take mandatory annual withdrawals throughout the 10-year period if the deceased owner was already subject to their own required distributions. Unsurprisingly, this caught many practitioners off guard and created a planning conundrum given that the proposed regulation is still not finalized but is theoretically retroactive to 2020. Recognizing the confusion, the IRS has provided relief until the final rules are firmed up, but the process has been messy.

Legislation passed by Congress and signed by the President is only the beginning of enacting a new law. The implementation is carried out by relevant departments who must create voluminous regulations and procedures that define how the law will be interpreted, implemented, and enforced. In the case of tax law, the IRS and the Treasury Department must digest the legislation and then create the rules of the road. Proposed rules are subject to an extended period of public comment during which stakeholders submit feedback which is considered by the agency. Public hearings on the proposed rules may also follow and changes incorporated based on this evaluation process until the finalized rules become effective.

The IRS began evaluating the complicated SECURE Act immediately but did not issue proposed rules until February of 2022. The proposed regulations included the mandatory distribution requirements for non-spousal beneficiaries over 10 years if the owner was already taking distributions. The degree of surprise the proposed rule engendered is unusual and is especially impactful since taxpayers’ best guesses has been wrong for 2 years.

Regulatory agencies recognize the potential for confusion throughout this process, and the IRS has made allowances in this case. In 2 subsequent rulings, the tax agency has effectively waived the requirement for non-spousal mandatory distribution for tax years 2020 through 2023. That means no penalty will be assessed for failing to take the required distributions for those years, although the original 10-year depletion window is still in effect and many beneficiaries will likely be required to begin mandatory withdrawals in 2024. Consultation with a tax advisor is especially important here since the waivers could mean a much higher tax bill for larger distributions later in the 10-year window and might warrant considering a withdrawal in 2023 to reduce the subsequent hit, depending upon individual circumstances.

If a non-spouse inherited an IRA from someone who had not yet started taking minimum required distributions, there is no requirement to take annual withdrawals, but the account still must be fully distributed by the end of year 10 or any time before. The MRD rule only applies if the original owner was already required to take their own MRD.

In general, these changes only apply to IRA accounts whose owner died after 2019. Accounts inherited prior to SECURE continue under the original rules. And the Act created a couple of additional classes of beneficiaries including minor children, disabled or chronically ill individuals, and beneficiaries 10 years or less younger that the owner who can still use the stretch. For all other inheritors from someone other than a spouse, the new 10-year rule applies and the mandate for annual distributions depends on whether the owner was already taking them.  Simple, right?

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