Background
In 2019 when the original SECURE Act was passed, the landscape of tax and retirement planning changed. Later, in 2022, the IRS gave proposed regulations regarding the previously passed SECURE Act. Just last month on July 18th, the IRS issued final regulations. While these final regulations cover a variety of topics, one of the key questions they answered was regarding the Required Minimum Distribution (RMD) rules for inherited retirement accounts.
When the SECURE Act was passed it created a new rule called the “10-Year Rule”. While this rule varies slightly depending on who the designated beneficiary is and how old the decedent was when they passed away, essentially what this rule states is that from the date of death a clock starts where the beneficiary must distribute the account in its entirety by December 31st of the 10th year. Prior to this final guidance, beneficiaries had the option to take the entire account balance in year 1, wait until year 10 to distribute it all or take distributions each year. It did not matter so long as the account was emptied at the end of 10 years.
Another rule that is important to know is the “Stretch” rule. While this rule was in place before the SECURE Act and was largely replaced with the 10-year rule described above, it remains relevant in certain situations. This rule states that when inheriting an account, the beneficiary will “stretch” the RMD over their own lifetime. This was a major benefit for younger beneficiaries because it would only require a small distribution each year, which would help maintain lower taxable income. The downside was you had to take the distribution each year or face a penalty.
Final Rules
The IRS has divided the finalized rules based on what type of beneficiary you are. The first two categories are either “Designated” or “Non-Designated” beneficiaries. We will not discuss “non-designated” beneficiaries here. A “designated” beneficiary is simply a person or entity that the account owner intentionally assigned as the beneficiary of the account.
The IRS has further subdivided the designated beneficiary into two sub-categories, “Eligible Designated” or “Non-Eligible Designated” beneficiary. A final consideration is if the original account owner died prior to, on, or after the date they would have been required to start their RMD, (i.e. their “Required Beginning Date” or RBD).
Eligible Beneficiary
To qualify as an eligible beneficiary, you must be one of the following:
- Surviving Spouse
- Disabled Person
- Chronically Ill Person
- Person less than 10 years younger than the decedent
- Minor Child
In the case of non-spouse eligible beneficiaries where the original account owner died prior to their RBD the beneficiary may take the remaining account balance based on the stretch rule or the 10- year rule. If the original account owner passed away on or after their RBD the beneficiary is required to use the stretch rule.
Surviving spouses have an additional option, which is to make a spousal rollover. This will transfer the account from being an “Inherited IRA” into the surviving spouse’s own IRA. One important nuance is that if a surviving spouse originally chooses the inherited IRA option with the 10-year rule and later changes the account to a spousal rollover (i.e. their own IRA) they would then be subject to something called “Hypothetical RMDs”. This will be the total amount of all previous RMD’s that would have been required.
Non-Eligible Beneficiary
This category is any other designated beneficiary that is not considered “eligible”. If the decedent passed prior to their RBD then the 10-year rule must be chosen. If they died on or after their RBD then the 10-year rule and the stretch rule over the longer of the beneficiary or decedents life are both applied.
Put simply, in years 1 through 9 non-eligible beneficiaries must take the applicable RMD, then in year 10 distribute the remaining balance. The important change in this category is they are no longer allowed the flexibility described above. They must now take a distribution each year or be subject to a penalty. This new rule will not be retroactively enforced and will not apply until 2025.
Examples
- Assume you are a 60-year-old inheriting a $500,000 IRA from your father, who passed away at age 85. Prior to his passing, he was taking required minimum distributions based on his lifetime. Upon inheriting the account, a new actuarial calculation will determine your RMD based on your lifetime, since you are younger. Suppose this calculation requires you to withdraw approximately $15,000 per year. In years 1 through 9, you must withdraw at least $15,000 annually to satisfy this RMD requirement. In year 10, regardless of the remaining balance, you must distribute the entire remaining account balance. Therefore, it may be wise to consider taking more than the RMD each year (or in certain years) in order to spread out the tax burden.
- Your younger sister named you as the beneficiary of her IRA. At the time of her passing, she was 75, and you were 78. Since you are older than she was, the RMD calculation will still be based on her lifetime. Following the same process, in years 1 through 9, you must withdraw at least the RMD amount calculated based on her lifetime. In year 10, you are required to distribute the entire remaining account balance.
- Your spouse passed away recently, and you now must decide whether to receive these funds in an Inherited IRA or do a spousal rollover and move the funds directly into your own IRA. Because you are 73 years old and do not want to be required to distribute a higher amount each year, you decide to leave the account as an inherited IRA subject to the 10-year rule. Now it is 9 years later and there is still a considerable balance in this Inherited IRA. Because you would have to take the entire remaining balance in the 10th year you decide to do a spousal rollover, moving this inherited IRA into an IRA in your name. When you make this rollover, you will be subject to the hypothetical RMD rule discussed previously. Because you are RMD age you will need to calculate what your RMD requirements would have been in each of the previous 9 years and take that distribution prior to making the spousal rollover.
Conclusion
These finalized rules can be complex and challenging to navigate, with numerous caveats in each section. The final guidance from the IRS underscores the importance of clear communication with your advisor and tax and legal professionals. Although some flexibility has been removed with these regulations, crucial planning is still required to achieve the optimal outcome.
