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INHERITING AN IRA …. The Rules Have Changed
Barbara Trombley, CPA
In the last few decades, investing in retirement plans has become non-negotiable. Social security isn’t enough to support us in retirement. If you received a tax deduction when you contributed to your plan, any distribution will be fully taxable to you when you take it. But what happens when you inherit someone else’s plan? Or if you die and leave your plan to your spouse or children? The Secure Act (Setting Every Community Up For Retirement Enhancement) passed in 2019 and changed many of the rules for inherited retirement accounts. For simplicity, we will discuss Roth IRA’s and Traditional IRA’s in this article.
The rules for a spousal inheritance of a Roth IRA haven’t changed with the Secure Act. A spouse can assume the Roth as their own and follow regular Roth IRA rules. The rules are different when the beneficiary is not a spouse. Pre-Secure Act, a non-spouse could open an Inherited Roth IRA and take distributions over their lifetime. But after the passage of the SECURE Act, this provision was eliminated. Roth IRA beneficiaries are now required to withdraw all funds within 10 years of the original account holder’s death. Only an inheriting spouse can stretch the Roth IRA distributions out for a lifetime. Any other beneficiary, such as a child, must close out the account within a decade. A tax loophole has been closed. No longer can you experience compounding growth with tax deferral over your lifetime!
With Traditional IRA’s, spousal inheritances are and have always been simple. A spouse can assume the IRA as their own and take distributions based on their own life expectancy. In most cases this would be the desirable choice (for tax purposes) as it allows the spouse to take out and pay taxes on only what is required by law (as set by the IRS RMD tables).
What if you inherit an IRA from a non-spouse? Many people have aging parents that have not depleted their IRA’s. Pre-2019, the rules were simple. If you inherited an IRA, you could set up an Inherited IRA account, and take out minimum distributions based upon your age. For instance, if you were 50 years old and inherited a $500,000 IRA, your first-year distribution, using the IRS Single Life Expectancy table would be less than $15,000! The bulk of the account could grow tax-deferred while you would make slightly larger withdrawals as the years passed. This made for a popular estate planning strategy where grandparents could leave their retirement accounts to their young grandchildren who would only need to take out small distributions on a yearly basis. The Secure Act changed this rule. Currently, a non-spouse that inherited an account after January 1, 2020, has ten years to empty out the account. The non-spouse can take out some each year to minimize taxes or the whole amount in year 10. Exceptions are made for disabled or chronically ill individuals, those whose age is within 10 years of the deceased, and direct descendants under the majority age of 18 (although the ten-year clock starts ticking once they reach 18).
Unfortunately, this is not the end of the ruling. When Congress passes laws, the IRS issues guidance on how to interpret the law. The IRS is currently proposing new regulations on how to interpret the 10-year withdrawal rule. Comments to the IRS were due on May 22, 2022, and then their findings will be issued. What is at stake is whether any distributions at all need to be taken over the 10 years, or can the beneficiary wait until year 10 to fully liquidate an IRA. The IRS may say that required minimum distributions need to be taken each year using the “at least as rapidly rule” meaning that you may need to calculate your own life expectancy as well as the deceased owners and take a payment “at least as rapidly” as the deceased would have. Also, when the IRS finally issues their guidance, it will be retroactive. Will it apply retroactively to 2020 and 2021 RMD’s? It is hard to believe that they will subject taxpayers to the hefty penalties that go along with missed RMD’s, namely a 50% penalty!
What should people do that have recently inherited IRA’s? Seek out advice from your accountant or financial planner and possibly wait until later in the year to take a distribution after the ruling is clarified. Again, the law for the Secure Act was passed in 2019. We are waiting for the IRS to further interpret the way they see the rules and we all have to act accordingly. This situation has been called “a nightmare” and “a mess” by many in the financial industry. For many, this subject may be dry and confusing, but it is too important to ignore. Try not to be caught off-guard because the financial penalties may be harsh!
Securities offered through LPL Financial. Member FINRA/SIPC. Advisory services offered through Trombley Associates, a registered investment advisor and separate entity from LPL Financial.
This material was created for educational and informational purposes only and is not intended as ERISA tax, legal or investment advice.