Inherited IRA Required Distribution Rules Change, Again.

The rules surrounding Required Minimum Distributions (RMDs) from inherited retirement accounts have always been complex. After the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 enacted sweeping changes, the rules were made all the more complicated.  One of the most impactful changes was the elimination of the “stretch” provision for inheritances which allowed most beneficiaries to take small amounts out of the account(s) annually based on their own life expectancy. Under the new rules, many inheritances that occur after January 1, 2020 will be subject to a new 10-year rule.  However, the wording used for this new rule left a major question that the IRS is now trying to answer.

First, let’s discuss to whom this applies. The SECURE Act breaks beneficiaries of retirement accounts down into two categories; Eligible Designated Beneficiaries (EDB) and Non-Eligible Designated Beneficiaries (NEDB).  EDBs include the following:

• Surviving Spouses,

• Children younger than the age of majority (21),

• Individuals with disabilities,

• Chronically ill individuals, and

• Individuals who are not more than 10 years younger than the original account owner

EDBs are still allowed to stretch RMDs over their life expectancies as before, though there is some nuance on the calculation methods applied based on the age of the original owner at death.  Everyone else, including trusts, whose beneficiaries are not all EDBs, now are subject to the new 10-year rule which requires that the entire account balance be distributed by the end of the 10th year following the year the original owner passed (if the owner passed in 2022, the account must be drained by 2032).

The impacts of this change for NEDBs are that inherited retirement account dollars get to spend less time in their tax qualified state and, in the case of pre-tax money, there will be larger taxable distributions that will likely result in higher tax bills for beneficiaries.

When Congress passed the SECURE Act they used ambiguous wording around the new rule, pointing back to an existing rule called the “5-year rule” in several cases.  It did not specifically state whether those subject to the 10-Year rule would also be required to take annual distributions based on their life expectancy along the way.  The common interpretation of this was that annual distributions would NOT be required until the end of the 10th year in the same way they are NOT required under the referenced 5-year rule.  As such, most people chose not to take distributions until they had to do so.

The IRS then gave a series of conflicting guidance on the topic until a new proposed regulation was issued for comment in February of 2022.  The proposal would require annual life expectancy-based distributions in years 1-9 when the original owner had already reached their Required Beginning Date and were required to take RMDs themselves before they passed.  Those who inherit a retirement account from someone who passed before reaching their Required Beginning Date will not have to take any annual distributions until the end of the 10th year.  That includes all beneficiaries of Roth IRAs, which have no Required Beginning Date because they have no RMDs.

These proposed regulations have not been finalized at the time of this writing, though they are expected to be finalized and published for tax year 2023.  Therefore, we are expecting that many beneficiaries that haven’t had to take funds out of their inherited IRAs previously will likely have to.  But what about those beneficiaries that, under the new rules, should have taken distributions in years 2020-2022 but chose not to do so? 

The good news is that the IRS provided relief against penalties for missed Required Distributions for those in this situation for tax years 2020-2022.  Therefore, if you were supposed to take a distribution and didn’t you will NOT be penalized.  That is not expected to be the case for 2023, assuming the final regulations are published as expected.

The next question, which is still pending, is whether these beneficiaries will be required to take extra distributions in 2023 to make up for the missed distributions.  The proposed rules don’t specifically address this, though the release does state that the new rules, which directly require the annual distributions described above, will apply “no earlier than the 2023 distribution calendar year.”  As such, it is our expectation that catch-up distributions will likely NOT be required.  We will continue to monitor for the final release of these regulations and will provide an update as soon as the path forward is clear.