The Internal Revenue Service has finally clarified the rules on required distributions from inherited retirement accounts, like IRAs, 401(k)s and 403(b)s.
The rules affect most heirs, but not spouses. The new guidance applies to both future inheritors and those who inherited retirement accounts since 2020, who have been in limbo waiting for the rules.
Prior to 2019, a beneficiary was permitted to “stretch out” inherited retirement account withdrawals over their lifetimes, meaning decades of smaller payouts and more growth potential.
In 2019, a new law said that many of those who inherited retirement accounts had to take the money out within 10 years. Confusingly, though, the law didn’t specify whether they had to take out money each year, or could wait until the final year to take out all of the funds.
Skipped Distributions
Because there has been confusion about the new rules, over the past few years many people didn’t take distributions. The IRS has effectively excused this, saying it won’t penalize people in this situation for failing to take required payouts for the years 2021 through 2024.
Some people who inherited IRAs in the years 2020 to 2023 held off on taking withdrawals, hoping the IRS would give them a few extra years to deplete the account. But the final rules don’t extend the 10-year period.
The New Rules
The final regulations distinguish between instances in which the original account owner had started taking their Required Minimum Distributions (or RMDs) before they died, and instances when they died before starting their RMDs. They also differentiate between “eligible” designated beneficiaries and designated beneficiaries.
Eligible beneficiaries are an original account owner’s spouse, someone disabled or chronically ill or another beneficiary “not more than 10 years younger,” such as a younger sibling.
If the original account owner had not already begun taking RMDs, then an eligible beneficiary can either choose to take RMDs consistent with their life expectancy or elect the 10-year rule. If the participant died after starting to take RMDs, then the beneficiary can take RMDs consistent with the longer of their life expectancy or that of the participant.
A partial exception from the 10-year rule is made for heirs younger than 21: Their 10-year clock does not start until they turn 21. At age 21, the beneficiary will have to take RMDs every year consistent with their life expectancy, which will tend to yield smaller amounts, and must then deplete the account by the end of 10 years.
The 10-year rule is mandatory for ineligible beneficiaries, which are often adult children of the original account owner.
If the original account owner had already begun taking RMDs, the ineligible beneficiary must take RMDs “at least as rapidly” as the account owner had been. In the event there are assets remaining at the end of 10 years, the remaining balance must be fully distributed.
If the original account owner had not taken an RMD, then the ineligible beneficiary does not need to take RMDs and can choose to simply withdraw the entire balance at the end of 10 years.
A Potential Tax Balloon
With the new rules, inheritors should be aware that they might face a large tax bill in the future if they only take out the required distributions each year.
As an example, assume you inherited a $500,000 IRA in 2020 at age 50. You didn’t take distributions between 2021 and 2024, as you were waiting on the IRS to clarify the rules. If the IRA had a 5% return, its market value now would be about $650,000. In 2025, the required distribution would be a bit more than $20,000.
If you continued taking out only the minimum amount, by 2030 – the year the account would have to be fully depleted – there would be a required distribution of roughly $700,000.
Multiple IRAs and Caveats
The final rules don’t completely end the potential confusion. Congress layered the new law on top of older IRA rules, so inheritors can be left with multiple IRAs with different payout rules.
For example, a retiree may be taking RMDs from their own IRA under one set of life expectancy rules, but may need to take distributions from an IRA inherited from a parent using different calculations.
And people who inherited accounts before 2020 are still subject to the old rules, which require annual withdrawals over their expected lifetimes.
Contact us today with any questions about inherited retirement accounts and required distributions.
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