When you inherit an Individual Retirement Account (IRA) or other type of retirement account, you’re faced with a set of rules dictating the minimum amounts you must withdraw annually. These are Required Minimum Distributions (RMDs), and they have significant implications for how much tax you’ll pay and how you can manage the inherited funds over time.
The “Setting Every Community Up for Retirement Enhancement” (SECURE) Act, signed into law in December 2019, marked a significant shift in how these distributions are handled. And the changes have only continued.
In this article, we look at these changes and what they mean to you.
The era of the stretch IRA
Before 2020, beneficiaries could benefit from what was known as the “stretch IRA” provision. This allowed non-spouse beneficiaries to “stretch” the distributions – and the tax obligations – over their own lifetimes. This approach allowed for potentially decades of continued growth without immediate tax implications.
The SECURE Act and initial misunderstandings
All that changed with the arrival of the SECURE Act in January 2020. Under the new guidelines, these beneficiaries were now subject to a 10-year rule that stipulated that the entire balance of an inherited IRA had to be withdrawn within 10 years following the account holder’s death.
The introduction of the 10-year rule brought a wave of misunderstandings and confusion. One widespread misconception was the belief that beneficiaries had the flexibility to choose not to take any distributions until the very end of this 10-year period. Many thought that the distribution schedule within that timeframe was entirely at their discretion as long as the entire account was emptied by the deadline. This misunderstanding stemmed from a lack of clarity in the initial guidance and widespread speculation about how the rules would be enforced.
(The SECURE Act did carve out an exception for eligible designated beneficiaries: minors, disabled people, the chronically ill, and individuals less than 10 years younger than the IRA owner can still stretch the IRA distributions over their lifetime.)
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More changes adds to more confusion
The IRS then dropped a bombshell in February 2022 that required non-eligible designated beneficiaries to take distributions throughout the 10-year period, not just at its conclusion.
Specifically, the IRS’s new stance was that if the original account holder was subject to RMDs at the time of their death, then the non-eligible beneficiaries would need to take yearly distributions based on their own life expectancies. Calculating these annual distributions involved using the IRS’s Uniform Lifetime Table to determine the beneficiary’s life expectancy, then reducing that figure by one each year.
Needless to say, these new rules significantly complicated the landscape for beneficiaries and their advisers. They also underscored the importance of staying on top of regulatory updates and understanding how such changes can impact inherited retirement assets.
The IRS response to confusion and non-compliance
In response to widespread confusion and the difficulties many faced in complying with the new rules, the IRS announced in February 2022 that they would waive penalties for those who had missed their RMDs based on their misinterpretation of the changes. This move was widely seen as a direct acknowledgment of the complexity and uncertainty the proposed guidance had created.
The IRS extended this waiver in July 2023, giving beneficiaries and their advisers additional time to adjust their strategies and ensure compliance without the looming threat of penalties.
Awaiting final guidance
The IRS has said that they expect to release final guidance in 2024. These rules are expected to clarify the landscape and offer a more definitive path forward for managing inherited retirement accounts.
For beneficiaries, the lack of clear, final rules has made it challenging to plan strategically for the future. They’ve had to navigate potential tax implications and distribution strategies without a firm understanding of what the future holds.
For financial planners, the final rules will not only dictate how they advise their clients regarding inherited IRAs, but also impact broader retirement and estate planning strategies. Clear, definitive guidelines will allow them to provide more accurate, effective guidance, and help their clients maximize the benefits of their inherited assets.
Navigating the future
Since the introduction of the SECURE Act and the subsequent changes implemented by the IRS, the rules surrounding the management of inherited retirement accounts have been in flux. These changes underscore the importance of staying informed and adaptable. As regulations evolve, so too must our strategies for estate and retirement planning.
If you’re navigating these changes, consider consulting with a financial adviser to review your plans and prepare for what’s ahead. Considering these ever-evolving rules, staying proactive is key to optimizing your financial future.
Hunter Yarbrough, CPA, CFP, is a vice president and financial adviser with CapWealth. He is passionate about taking a holistic view of personal finance, including investments, taxes, retirement, education, estate planning, and insurance. For more information about Hunter and CapWealth, visit capwealthgroup.com.