Proposed regulations for inherited IRAs bring unwelcome surprises
The first significant legislation signed into law addressing retirement savings since 2006 was in late 2019. Many improvements to retirement and estate planning methods have emerged from the SECURE Act. But it has also created questions. So, the IRS has been filling in the gaps. The most recent announcement of new regulations in February 2022 leaves many taxpayers perplexed and unclear about what to do. One of the most notable aspects of the proposed regulations is an unexpected interpretation of the so-called “10-year rule” for an inherited IRA and other defined contribution plans. This interpretation, which contradicts previous IRS guidelines, might result in higher tax bills for some recipients if finalized.
The inherited IRA
Beneficiaries of inherited IRAs may “stretch” the required minimum distributions (RMDs) on such funds throughout their whole lives before the SECURE Act was adopted. The stretch period could last decades for younger heirs. That allows them to accept lesser payouts and avoid taxes while the accounts expand.
The SECURE Act abolished the regulations that permitted many heirs to have stretch IRAs to speed up tax collection. Generally, the law requires distributing the entire amount of an IRA or defined contribution plan within ten years of death for those who die in 2020 or later. This regulation applies whether the deceased person died before, on, or after the required beginning date (RBD) for RMDs. The RBD under the SECURE Act is age 72.
There are exceptions to the SECURE Act for the following sorts of “eligible designated beneficiaries” (EDBs):
- Surviving spouses
- Children younger than “the age of majority”
- Individuals with disabilities
- Chronically ill individuals
- Individuals who are no more than ten years younger than the account owner
EDBs may be able to defer payments for the rest of their lives. Or, if the deceased died before the RBD, they might elect the 10-year rule treatment. Therefore, when an EDB dies, the leftover sums will be subject to the 10-year rule.
The 10-year rule
The 10-year rule also applies to trusts. For example, the law applies to see-through or conduit trusts that employ the oldest beneficiary’s age to prolong RMDs and prevent young or spendthrift beneficiaries from quickly depleting inherited accounts.
Before the proposed regulations, the expectation of non-EDBs was to be able to wait until the conclusion of the 10-year term. It was to also take the entire account as a lump-sum distribution rather than annual taxable RMDs. This distribution method is often preferred, primarily if an heir works for ten years and has a higher tax rate. If there is a requirement for such heirs to take annual RMDs, they may face higher taxes than expected.
The IRS has now added to the confusion by issuing contradictory guidelines. In March 2021, the revised Publication 590-B, “Distributions from Individual Retirement Arrangements (IRAs),” indicated that yearly RMDs would be required for years one through nine after death. However, edits a few months later stated that “the beneficiary is authorized, but not obligated, to take distributions before” the 10-year limit.
That was a short-lived job. In some instances, the proposed regulations announced in February call for annual RMDs.
Proposed regulations for the inherited IRA
According to the proposed regulations, non-EDBs who inherit an IRA or defined contribution plan before the deceased’s RBD will be able to satisfy the 10-year limit. They can do so by taking the entire amount before the end of the calendar year, including the 10th anniversary of the death. However, the regulations change when the deceased passes away or after the RBD.
Non-EDBs must take annual RMDs (based on their life expectancies) in years one through nine, receiving the remaining balance in year ten. The yearly RMD rule limits beneficiaries’ options and may cause them to fall into higher tax brackets during specific years. (Note that there is no requirement of RMDs for Roth IRAs, so beneficiaries must empty the funds at the end of ten years.)
Apart from the tax ramifications, this posture poses a problem for non-EDBs who inherited an IRA or a defined contribution plan in 2020. According to the proposed regulations, they should have taken a yearly RMD for 2021. Failure to do so would result in a penalty equal to 50% of the RMD taken. However, the proposed regulations only came out in February 2022.
Tax planning for non-EDBs
What about non-EDBs who are minors when they inherit the account but achieve the “age of majority” within the 10-year term following the death? While the beneficiaries are minors, they can employ the stretch rule. Still, once they reach the age of majority, the annual RMD will apply (assuming the deceased died on or after the RBD).
Non-EDBs will need to engage in tax planning considerably sooner than they would if the IRS’s most recent interpretation of the 10-year rule holds. For example, taking more than the annual RMD amount could help spread the tax cost over the ten years. They may also choose to change annual payout amounts for a particular tax year based on other income or deductions.
Clarification of the exceptions
The proposed regulations define a few critical terms when deciding whether or not an heir is an EDB. For example, regardless of how state law defines the term, they define “majority” as 21 years old.
The age of the beneficiary determines what constitutes “disability.” Suppose the beneficiary is under the age of 18. In that case, they must have a medically determinable physical or mental impairment that causes significant functional limits. It must also expect to end in death or be of long-term and indefinite duration. Assessment of beneficiaries over 18 is based on whether they are “unable to engage in substantial gainful activity.”
The U.S. Treasury Department is taking public comments on the proposed regulations through May 25, 2022. It will hold a public hearing on June 15, 2022. Non-EDBs missing the 2021 RMD deadline may want to wait until the end of the year to see if the IRS issues more clear guidance. Ideally, including relief for those who relied on the version of Publication 590-B stating no requirement of RMDs. Contact our RRBB accountants and advisors to assess the best course of action for you in light of recent events.
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