Almost five years after the original SECURE Act created the new 10-year rule, and more than two years after issuing their proposed interpretation of the rules, the IRS announced it plans to adopt essentially all of their original regulations regarding distributions from inherited retirement accounts.  This includes the requirement that some – but not all – beneficiaries must take distributions from the account during the first nine years after the original owner’s death.

The IRS also clarified that the penalty waivers given to beneficiaries over the last few years will not cause any change in the application of the 10-year rule.  Beneficiaries will not be required to “make up” any required distributions that were skipped as a result of those waivers, and won’t be required to begin distributions until 2025, but there also won’t be any extension of the 10-year time period for withdrawals.  As a result, most beneficiaries of IRA owners who died in 2020 through 2023 must still plan to withdraw the account balance during the original 10-year window.

Background

The SECURE Act in 2020 created a new rule requiring most beneficiaries of inherited retirement accounts to liquidate those accounts within 10 years of the owner’s death (the new “10-year rule”).  The spouse or minor child of the decedent, among others, are exempt from this rule, but most beneficiaries are no longer eligible for the old “lifetime stretch IRA” treatment.

In 2022, the IRS issued proposed regulations regarding the 10-year rule.  Among the proposals was a requirement that some beneficiaries subject to the new 10-year rule must also take minimum distributions in each of the first nine years after the owner’s death.  This would include cases where the decedent died after their own required beginning date (RBD) for RMDs on the account.  This rule caught many beneficiaries and planners off guard, leading the IRS to issue a notice later in 2022 saying beneficiaries will not be penalized for not taking those RMDs for 2021 or 2022.  As a result, many beneficiaries chose to not take the RMD that otherwise was required.  That waiver was extended by the IRS in 2023 and again in 2024.  As was expected, however, the IRS has now made those proposed distribution rules final effective for 2025.

Impact of Final Rules

Beneficiaries of inherited IRAs now know for certain their distribution requirements:

• If the owner died prior to 2020, the beneficiary uses the old lifetime stretch IRA rules.  In most cases, these beneficiaries are subject to RMDs every year beginning the year after the owner’s death.  This applies to both Traditional and Roth-IRAs.
• If the owner died after 2019 and the beneficiary is an eligible designated beneficiary (EDB), they also remain subject to the lifetime stretch IRA rules.  EDBs include the following:
  • The surviving spouse or a minor child of the decedent.  For purposes of this, a minor is now defined as someone under age 21, regardless of the law in their state.
  • Someone who is defined as disabled or chronically ill.  An individual who qualifies for Social Security
    disability benefits is deemed to automatically meet this definition.
  • Someone who is less than 10 years younger than the decedent, which includes a beneficiary older than the decedent.
• If the owner died after 2019 and the beneficiary is NOT an EDB, the beneficiary must empty the account by December 31 of the year containing the 10th anniversary of the IRA owner’s death.  In addition:
  • If the owner died on or after their own Required Beginning Date (RBD) for RMDs, the beneficiary must continue taking RMDs from the account over years 1-9 after the owner’s death.  Those RMDs are generally based on the beneficiary’s age the year after the owner’s death.  RBD is defined as April 1 of the year after the year the owner reaches the age where they’re subject to RMDs.  This would either be age 72, 73 or 75, depending on the year the owner was born.
  • If the owner died before their own RBD, the beneficiary does not have to take any RMDs during years 1-9 after the owner’s death.
  • If the inherited account was a Roth IRA, the 10-year rule applies but no RMDs are required during
    years 1-9 in any case.

Planning Around These Rules

The penalty waiver over the last few years has allowed affected beneficiaries of inherited IRAs to let those accounts grow on a tax-deferred basis, but now the tax bill on that growth is coming due.  This is especially true for those beneficiaries of IRA owners who died in 2020, as 2024 is already the 4th year of their 10-year window to deplete the account.  If those beneficiaries wait until 2025 to take their first RMD – as they’re allowed – they will have just six tax years to spread out their distributions, potentially leading to a large distribution in the final year.

Also remember that the required minimum distribution amounts in the first nine years are based on the beneficiary’s age and the Single Life Expectancy table published by the IRS.  These factors are meant to spread distributions over the beneficiary’s life expectancy, which may be much longer than the 10 years they are allowed under the new rules.  As a result, beneficiaries who only take the minimum distribution may again be in store for a large distribution in the 10th and final year.

For example, a 55-year-old beneficiary has a life expectancy factor of 31.6 years, which equates to about 3.2% of the account balance in the first year.  By the 9th year after the owner’s death, the required withdrawal would have increased to only 4.2% of the balance.  With just nominal growth over that time, the IRA balance that must be withdrawn in year 10 could easily be more than the value at the time it was inherited, even after the nine prior withdrawals. 

In cases where the IRA owner died prior to their own RBD and beneficiaries are not required to even take RMDs in the first nine years, this issue can be further exaggerated.  In those cases, a rate of return of just 7.2% over that 10-year period will leave the beneficiary with an IRA twice the size of what they inherited, all of which must be distributed that last year.

Therefore, beneficiaries should carefully plan for their withdrawals over the remaining distribution period, finding the right combination of tax deferral and avoiding distributions taxed at unnecessarily high tax rates.  Delaying distributions as long as possible may be appropriate for some beneficiaries, but others will likely benefit from planning those distribution amounts over the full 10-year window.

Robert W. Baird & Co. Incorporated. Baird does not provide tax advice. Contact your tax professional.