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Individual retirement accounts, or IRAs, are a tax-advantaged way to save for retirement. If you have an IRA, you know that there is a stiff early withdrawal penalty for early withdrawals (before age 59 ½, with certain exceptions). You probably also know that you must start taking required minimum distributions (RMDs) from your IRA when you turn 72 (or 70 ½ if you reached that age before January 1, 2020). In short, it’s important to avoid violating the rules about IRA withdrawals, or it could cost you a significant amount of money.
What happens if an IRA owner doesn’t withdraw all funds in the account before they die? As with their other assets, the IRA will be inherited by someone else, often a spouse or adult child. With an inherited IRA, there are still required minimum distributions. However the rules about RMDs from inherited IRAs are different, and, what’s more, they are somewhat up in the air due to recent legislation. The IRS has proposed regulations to clarify when and how distributions must be taken from inherited IRAS, but there are still a lot of questions.
Inherited IRA Distributions Before and After the SECURE Act
In late 2019, the federal Setting Every Community Up for Retirement Enhancement Act (SECURE Act) was signed into law. The SECURE Act was designed to give workers expanded opportunities to participate in retirement plans and to keep money in those plans for longer—that’s why you now don’t need to take RMDs from your IRA until age 72, rather than 70 ½, and you can keep contributing to your IRA after you turn 70 1/2. So far, so good. But the SECURE Act led to confusion about withdrawals from inherited IRAs.
Prior to the SECURE Act, a person who inherited an IRA from someone other than their spouse could “stretch” RMDs over their expected life span. Because distributions from a traditional IRA are taxable as income, being able to stretch them over your lifetime meant that your distribution each year, and the associated tax obligation, would be lower.
With the passage of the SECURE Act, the opportunity to stretch distributions was eliminated, with a few notable exceptions. The act now requires most non-spouse beneficiaries who inherited an IRA on or after January 1, 2020 to withdraw all funds in the account within 10 years. The 10 year rule did not apply to spouses or minor children of the original IRA owner, beneficiaries less than 10 years younger than the original IRA owner, or beneficiaries who are disabled or chronically ill as defined by the IRS.
Most tax experts interpreted the SECURE Act to not require RMDs of a certain amount in each of the 10 years, but here was no IRS guidance on this issue. The only requirement was that all funds be withdrawn by the end of the tenth year following the year in which the original owner died. (If the beneficiary does not withdraw all funds in that timeframe, the IRS claims a 50% penalty tax on whatever remains.) Theoretically, a beneficiary could wait until right before the end of the ten years and then withdraw all the funds, allowing them to defer taxes on the funds for a decade. Some advisors encouraged their clients to do just that.
Proposed IRS Regulations Regarding Distributions of Inherited IRAs
In February, 2022, the IRS proposed some regulations to shed some light on whether such lump-sum distributions would be permissible. Under the proposals, if you inherit an IRA from someone who had already passed the date when they would have to start taking RMDs, often referred to as “the required beginning date,” you would not be able to put off taking distributions yourself. You would have to take annual distributions and abide by the 10 year rule.
That could cause problems if you assumed, or relied on an advisor’s advice, that you didn’t have to take distributions in 2020 or 2021. You could face severe tax consequences—a 50% excise tax on the difference between the RMD and your actual distribution—for failing to take distributions for years in which you reasonably believed doing so was not required. In other words, if you took no distribution at all, the excise tax would be 50% of the RMD, per Section 4974 of the Internal Revenue Code.
What’s more, the proposed IRS regulations make reference to a section of the Internal Revenue Code that states that if the original IRA owner dies after they began taking distributions, the remaining account assets must be distributed “at least as rapidly” as they would have been using the distribution method used by the original owner as of the date of their death. Could that mean you would have less than ten years to make withdrawals from an inherited IRA?
As you can imagine, public comments on the proposed regulations reflected outrage at the unfairness of beneficiaries paying large penalties for failing to take distributions they couldn’t have known they were required to take.
IRS Notice 2022-53
In response to public comment on the proposed regulations regarding distribution of inherited IRAs, the IRS issued Notice 2022-53. This notice makes it clear that the IRS will not impose the Section 4974 penalty on beneficiaries who didn’t take RMDs after the enactment of the SECURE Act because they believed doing so was not required. If a qualifying beneficiary has already paid excise tax for a “missed” distribution, they are eligible for a refund.
Notice 2022-53 states that the final regulations regarding RMDs for inherited IRAs “will apply no earlier than the 2023 distribution calendar year.”
Not all beneficiaries are excused from having had to take RMDs. The relief applies only to those in which the original owner of an IRA or defined contribution plan died in 2020 or 2021, and in which the owner died after the date they were required to start taking RMDs.
If all of this is hard to digest, don’t worry: you’re not alone. But if you have inherited an IRA, you should plan to speak with your attorney or financial planner about when and how you will have to take distributions from your inherited IRA. To learn more, contact Estate Planning & Elder Law Services to schedule a consultation.