Inherited IRAs: Update to the Ten-year Window for Non-Spouses

The SECURE Act of 2019 eliminated the stretch provisions of the inherited IRA for most non-spouse beneficiaries. Previously, beneficiaries could “stretch” IRA required minimum distributions (“RMDs”) over their lifetimes. The ability to stretch RMDs over a long period was a very attractive feature for beneficiaries who did not need the extra taxable income associated with forced IRA distributions, especially those beneficiaries in a high tax bracket with a large inherited IRA. The SECURE Act drastically reduced the required payout period from a non-spouse beneficiary’s life expectancy to ten years, thereby significantly reducing the tax deferral benefit for these new IRA owners.

The financial planning industry understood this ten-year requirement to mean that taxpayers were considered compliant as long as the inherited IRA was emptied by the end of year ten. As a result, there were still planning opportunities available to taxpayers with lumpy or uneven income. However, new proposed IRS regulations provide otherwise. Specifically, if the proposed regulations pass as currently drafted, some non-spouse beneficiaries could be required to take annual RMDs in addition to depleting the inherited IRA by year ten.

SECURE Act

The SECURE Act divided IRA beneficiaries into three categories: Eligible Designated Beneficiaries, Non-Eligible Designated Beneficiaries, and Non-Designated Beneficiaries.

Eligible Designated Beneficiaries

Eligible Designated Beneficiaries were grandfathered into the pre-SECURE Act stretch technique. They include:

• Spouses
• Disabled as defined by Internal Revenue Code (IRC)
• Chronically ill as defined by IRC
• Individuals not more than ten years younger than the decedent
• Minor children of the decedent (only applicable until the minor reaches age of majority—age of majority being defined by each state)
• Certain trusts

Non-Eligible Designated Beneficiaries

Non-Eligible Designated Beneficiaries were subject to the new 10-year payout requirement. The 10-year requirement stated that the inherited IRA must be completely paid out by the end of the tenth year following the year of inheritance. For example, if an IRA owner died on June 28, 2020, the beneficiary (new inherited IRA owner) must withdraw the entire inherited IRA balance by December 31, 2030. They include:

• Non-spouses
• Certain trusts

Non-Designated Beneficiaries

Non-Designated Beneficiaries and the five-year rule associated with them are beyond the scope of this article. They include:

• Charities
• Your estate (Naming your will)
• Certain trusts

Proposed Regulations

The proposed regulations have added an additional layer of complexity to the IRA distribution requirements for Non-Eligible Designated Beneficiaries. This beneficiary category must consider whether the previous IRA owner died prior to their Required Beginning Date or on/after their Required Beginning Date. For context, the Required Beginning Date for IRA RMDs was age 70 ½ prior to the SECURE Act and is 72 years of age after the SECURE Act.

Non-Eligible Designated Beneficiaries whose previous IRA owners were not taking RMDs must still empty their IRAs within ten years. There do not appear to be additional negative impacts from the proposed legislation for this beneficiary category.

Non-Eligible Designated Beneficiaries whose previous IRA owners were taking RMDs must still empty their IRAs within ten years and must begin taking annual RMDs immediately. This is a significant change from the previous SECURE Act interpretation.

Planning Implications

Tax planning often involves managing income so that the taxpayer lands in the lowest marginal tax bracket possible. The flexibility of taking inherited IRA distributions at any time over a ten-year period offered a degree of control now eliminated for certain Non-Eligible Designated Beneficiaries. For example, prior to the proposed regulations, a 50-year-old inherited IRA owner considering early retirement may have postponed inherited IRA distributions until he/she retired (i.e. was in a lower tax bracket). This strategy does not appear to be available to Non-Eligible Designated Beneficiaries whose previous IRA owners were already taking RMDs.

For inherited IRAs opened in 2020, it is unclear if the IRS will penalize new inherited IRA beneficiaries for failing to take IRA distributions in 2021 as would be required under the proposed regulations. We are hopeful that the Treasury will provide further guidance on this issue when the final regulations are published.

As a result, we are asking that impacted Non-Eligible Designated Beneficiaries prepare for the following:

• Take an RMD in 2022 and each subsequent year and pay out the inherited IRA in full by the tenth year following the year of death.
• The possibility of having to take a larger RMD in 2022 to make up for not taking a RMD in 2021.

Because the SECURE Act guidance was unclear, the industry hope is that there should not be retroactive fines or penalties for taxpayers who did not take an inherited IRA RMD in 2021.

Summary

The proposed regulations would eliminate the flexibility and income control for certain inherited IRA beneficiaries by forcing them to take distributions every year until the inherited IRA is paid out in full at the end of year ten.

These proposed regulations remind us of guidance we provided in an article written before the SECURE Act was passed. Regardless of the outcome, the legislation under consideration is a good reminder of the importance of staying abreast of tax laws and continually reviewing your financial and estate plans. Can you answer these questions?

• Is my retirement income plan sustainable and tax efficient?
• Are my beneficiary designations up to date and appropriate?
• Should I consider Roth conversions? The ‘empty in 10-year rule’ also applies to Roth IRAs. However, while there is no income tax incurred by beneficiary distributions and RMDs are not required, it does limit the previous planning option to let these assets grow tax free longer than ten years.
• Is my portfolio allocation among my various accounts (IRA, taxable account, trust) structured to maximize family wealth after taxes?

Please let us know if you would like to discuss the issues raised in this article. As always, thank you for choosing Bragg Financial Advisors.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.