Final Rules for Inherited IRAs Closer to Being Known

Certain tax planning questions about inherited IRAs and other inherited retirement accounts have confounded beneficiaries and financial planners alike for nearly three years. The SECURE Act, signed into law in December 2019, effected changes to the way most non-spouse beneficiaries must empty the account. The IRS has left some details unaddressed since 2019, forcing tax advisors to make their best guess about how to treat required withdrawals. The IRS is finally about to clear up the uncertainty.

The SECURE Act eliminated the “stretch” provision for most non-spouse beneficiaries of inherited IRAs and other retirement accounts. Prior to 2020, non-spouse designated beneficiaries could take distributions over their life expectancies. However, most non-spouse beneficiaries inheriting accounts after 2019 are now required to empty the account by the end of the 10th year following the year of the decedent’s passing.

Prior to an IRS announcement in February 2022, tax professionals widely thought that a Non-Eligible Designated Beneficiary (anyone other than a surviving spouse, minor child of the decedent, disabled individual, chronically ill individual, or a person not more than 10 years younger than the decedent) would be able to take distributions in any manner, as long as the account was emptied by the end of the 10th year. Tax advisors followed this logic regardless of the decedent’s age (e.g. whether or not the original owner was already subject to RMDs).

In February, the IRS issued guidance with a surprising twist. Under proposed regulations, such beneficiaries must instead fully draw down the account over a 10-year period, and they must take RMDs in years one through nine if the account owner died after their own required beginning date. The required beginning date is currently April 1 of the year following turning age 72 for most individuals. The RMDs are calculated using the single life expectancy of the beneficiary. It’s calculated just as if the old stretch IRA rules are still in place, except the account must now also be emptied within 10 years.

This posed a problem for beneficiaries in the 10-year-payout camp who didn’t take RMDs in 2021 or 2022. Would they be subject to the IRS’ typical 50% penalty for failure to take RMDs? Luckily, this month the IRS gave the answer, and it’s no.

The IRS issued a notice clarifying that those beneficiaries don’t need to take distributions from such inherited accounts for 2021 or 2022. This gives them a free pass for RMDs while the final regulations are being worked out, with those regulations applying “no earlier than the 2023 distribution calendar year.”

While helpful, these updates don’t eliminate all the RMD uncertainty. The IRS is likely to impose RMDs for 2023 and beyond, but they might not. The IRS should issue the final rules in the first part of 2023, which is when the industry will have better information to work with.

Although not required this year, taking voluntary distributions in 2022 could be smart for some taxpayers to spread out the years in which income is recognized. This would be to avoid a larger distribution being taxed at potentially a higher tax bracket. Your tax advisor would be glad to help you evaluate your situation.

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