Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Changes in Inherited IRAs stay the same again

Taxpayers who inherit an IRA account from someone other than their spouse have received a reprieve this year. Last week’s IRS announcement grants IRA beneficiaries a fourth year of relief from mandatory withdrawals based on changes in the tax law contained in the Secure Act of 2019.

The sweeping act embodies the most significant enhancements to retirement saving since 2006. But as usual, the devil is in the details, some of which are still unresolved 4 years hence.

Congress included bipartisan retirement account reforms as a piece of a massive appropriations bill to fund the government for 2020. The Secure Act expanded 401(k) access to part-timers, increased the age for beginning required distributions, and lowered the penalty for missing a withdrawal. The act also eliminated the choice for non-spousal IRA inheritors to spread out depletion of the account over their own lifetime, referred to as a “stretch” option, and also extended the existing alternative 5-year withdrawal option to 10 years.

Evidently discerning that the existing rules were insufficiently opaque, Congress created a whole new class of IRA beneficiaries called Eligible Designated Beneficiaries, including spouses, minor children of the owner (until they reach 21), and certain people with disabilities or chronic illnesses. EDBs retain the stretch option, as does any inheritor who is less than 10 years younger than the deceased owner. For everyone else, the rules changed.

So now, if you inherit an IRA and are not a spouse or an EDB beneficiary, (an adult offspring for example), you are required to fully deplete the account within 10 years. That is still a pretty sweet deal by any measure.

Since the previous 5-year rule allowed one to wait until the very end to take the dough, and the act was silent on the topic, advisors logically assumed the 10-year rule would operate likewise. Spoiler alert: logic and the tax code rarely appear in the same paragraph. Two years after passage of the law, a proposed regulation from the IRS issued in 2022 dropped the hammer, requiring beneficiaries to take mandatory annual withdrawals each year throughout the 10-year period if the deceased owner was already subject to 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. Ever read Catch 22?

Legislation passed by Congress and signed by the President is only the beginning of a new law. Implementation is carried out by relevant government agencies who must create voluminous regulations and procedures that prescribe how the law will be interpreted, applied, 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 during enactment.

It has taken the IRS an unusually long time to finalize the rules governing inherited IRA accounts, so they issued the interim guidance in February 2022 giving a preview as to where they were headed. Included in that guidance was a waiver of the minimum distribution requirement for the first 2 tax years, 2021 and 2022. Technically, the relief consists of waiving the penalty for failing to take the required distribution you hadn’t been told you were required to take. Make sense?

The tax agency has reiterated its intention to issue final regulations “soon” but extended the waiver of required distributions for 2023 and again last week for 2024. That means that a non-spouse who inherited a traditional IRA in 2020 will (presumably) need to distribute the entire account over the remaining 6 years of the 10-year window. It is not at all clear at this point how the calculation will be made, an important consideration since the withdrawals are included in the beneficiary’s taxable income.

The ongoing confusion relates only to non-spousal beneficiaries more that 10 years younger than the deceased owner, and only if the owner was older than the required beginning date for mandatory withdrawals. Other inheritors have more clarity. If the original owner was not yet subject to minimum required distributions, the beneficiary can elect any timing within 10 years including all at the end.

These rules apply to traditional pre-tax IRA accounts. After-tax Roth accounts are treated differently, and more favorably. Non-spouse beneficiaries must still deplete the entire account over 10 years but are not required to make any required annual withdrawals. Distributions are tax-free, as long as the original Roth IRA had been open for at least 5 years. This presents some interesting estate planning opportunities for individuals with large IRAs who wish to pass significant assets to the next generation by converting to a Roth and paying the taxes now, setting up an enticing tax-free glide path for the owners’ remaining lifetime plus another 10 years for beneficiaries.

While a delay this long in rulemaking is unusual, it is useful to keep in mind that any deferral of taxation on an IRA windfall is a bonus. IRA accounts are taxpayer subsidies benefiting retirement savers, allowing them to postpone taxation until they withdraw the assets to finance their retirement. Extending tax subsidies to heirs is beyond the original intent behind the creation of IRA accounts, so any tax breaks to beneficiaries should be welcomed as a gift.

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