In the past, people who inherited 401(k)s and IRAs were allowed to “stretch” them: They could hold onto these accounts and keep getting their tax benefits for as long as they wanted.
Then came the SECURE Act of 2019, which changed everything. After this law passed, inheritors of these accounts had to liquidate them within 10 years after the accounts had passed into their hands.
What was left unclear, however, was whether they had to take the distributions at any point before the 10 years were up. In July, the Internal Revenue Service delivered its final ruling on the matter, and the news was disappointing to many beneficiaries: Most of those who have inherited a retirement account since 2020 must take minimum distributions every year if the original owner was already old enough to be taking the required minimum distributions. And the beneficiaries must withdraw whatever is left over by the end of the 10th year.
“The industry generally saw this coming,” said Gianna Giusti at KBBS Financial in Seattle. Two years ago, the IRS released proposed regulations that indicated what would happen, she said. But in certain cases, she added, it had made sense for clients to delay distributions just in case things went differently. “For instance, if a client was on the verge of retiring, we might have encouraged them to … begin distributions upon retirement. Now we don’t have that option.”
The required annual distribution is a minimum amount that’s calculated by dividing the IRA’s balance at the end of the previous year by the owner’s remaining life expectancy (using the IRS’s actuarial data). Giusti pointed out that clients could actually take larger distributions, which might be advantageous in low-tax years. “For every beneficiary, the best path is going to depend on their tax profile,” she said.
The rule, however, does not apply to spouses who inherit an IRA or 401(k). RMDs do not apply to inherited Roth IRAs either, experts add. Another exception is if the original account owner died before RMDs kicked in. The age at which RMDs must be taken by the original account owner has been going up in recent years. This year, it’s 73.
The new rule doesn’t apply to those who inherited before 2020, advisors say; they still have to take RMDs, if they are otherwise eligible, but they can spread the distributions throughout their lifetime. But the rule is retroactive to 2020, advisors say. It applies to nonspouses who inherited retirement accounts since the SECURE Act went into effect.
Nevertheless, experts explain, the rule specifically excuses from past due amounts those who did not take RMDs between 2021 and 2024—before the final rules were clarified. “We have been alerting our clients about the possible need to take RMDs during the 10-year period,” said Avery Neumark, senior consultant to CBIZ Marks Paneth, an accounting firm in New York, and a faculty member at Seton Hall University. “We were hoping for better results, [but] now we know for sure that there aren’t penalties if [clients] didn’t take them through 2024.”
The inheritors have to start taking them next year, though, he said, and the amount due then won’t be extra high if the inheritors didn’t pay over the past three years while the IRS was deliberating. These clients are also excused from the 25% penalty that’s usually imposed on skipped RMDs, he said.
Unfortunately for some, those who have inherited IRAs since 2020 and were waiting for the final ruling don’t get a reset on their 10-year clock, according to Denise Appleby, an IRA consultant in Grayson, Ga. “The account must be completely cashed out by year 10,” she said.
If the original owner died before taking RMDs, she explained, beneficiaries don’t have to take annual distributions. But they can withdraw money anytime in the 10-year period if they want to, perhaps to reduce the tax burden in the 10th year, when the account must be completely emptied, she said.
“Receiving a large distribution in year 10 could be detrimental if that occurs in a year when having a lower adjusted gross income is desirable,” said Ross Riskin, the Newtown, Conn.-based chief learning officer at the Investments & Wealth Institute. He cited years in which families are applying for financial aid for their children’s higher education, or hoping to qualify for tax credits that require certain income thresholds. “Tax-bracket management can be critically important,” he said.
Advisors say it’s a good idea for clients to consider ways of reducing the RMDs. For instance, they can move money from a traditional IRA or 401(k) to a Roth IRA Roth, said Ed Slott, an IRA expert and founder of Ed Slott & Co., a consulting firm in Rockville Centre, N.Y. The transfer will be a taxable event, he said, but Roths are not subject to RMDs. The funds can grow and be withdrawn tax-free.
Still, Slott stressed, those who inherit IRAs cannot convert them to Roths. So it’s the original owners who should make the change before they pass on, he said. “It’s best if beneficiaries inherent a Roth,” said Slott, rather than a traditional IRA or 401(k). An inherited Roth IRA can keep growing tax-free until the 10-year period is up. Even then, distributions from a Roth IRA are not taxed.
Advisors also suggest that clients could consider a qualified charitable distribution (QCD) if they are age 70½ or older. Up to $105,000 can be donated from an IRA in lieu of taking RMDs.
For most clients, though, experts recommend withdrawing roughly one-tenth of the inherited IRA every year, to even out the tax burden. “It makes sense to levelize their distributions to some extent … so that they’re not left with a tax bomb in year 10,” said Heather Zack, director of high-net-worth solutions at Commonwealth Financial Network in Waltham, Mass.
The IRS’s final rule might not have been a surprise, she said, but it could “change guidance” for clients who were “anticipating being in a lower tax bracket in the later years, perhaps because of retirement, who must now take those required distributions.”