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IRS Provides Relief for Certain Inherited Retirement Accounts

If you inherited a retirement account from someone who died in 2020 or later, you fall under the SECURE Act’s distribution rules. For most beneficiaries, the SECURE Act requires the account to be fully distributed within 10 years of the original owner’s year of death. Pursuant to proposed regulations issued earlier this year, certain beneficiaries that fall under the 10-year rule must take lifetime required minimum distributions (RMDs) during the 10-year period, which could be in 2021 and 2022. Forthcoming final regulations are to provide relief from the 50% penalty for those who didn’t take an RMD in 2021 or 2022. Anyone who paid a penalty for failing to take a 2021 RMD can apply for a refund.

For those who inherited a retirement account subject to the 10-year rule, the SECURE Act didn’t originally require the beneficiary to take annual distributions leading up to the 10th year. That meant the beneficiary could leave the balance intact and take it all in the 10th year or spread it out as they wished. They had control over the timing and could do tax planning to decide when and how it would be best to take distributions from the inherited retirement account.

The IRS said wait a minute, we didn’t mean that and came out with proposed regulations earlier this year that changed all of that. Under the proposed regs, beneficiaries that 1) fall under the 10-year rule and 2) inherited from an account owner who died after being required to take minimum distributions during their lifetime (i.e., after their required beginning date (RDB)), must take lifetime required minimum distributions (RMDs) during the 10-year period.

It helps a little bit that the IRS issued new life expectancy tables for 2022 and beyond. These new tables reflect our longer life expectancies and thereby reduces the annual RMD amount now that the balance is spread over a longer period. For example, at age 72, the life expectancy was extended an additional 2 years, making that year’s RMD be 3.65% of the account balance compared to 3.91% of the account balance under the prior uniform life expectancy table.

RMDs must begin the calendar year after the decedent’s death based on the life expectancy of the designated beneficiary, with the final distribution in year 10. That meant a distribution would’ve been required in 2021 and then 2022. But…2021 was already past when the proposed regs came out. Most of us concluded they wouldn’t be able to penalize anyone for missing a 2021 distribution when the rule didn’t yet exist. Many weren’t sure the proposed regs applied yet so weren’t intending to take a 2022 distribution.

Enter the IRS’s recent notice of their intention to issue final regs that will apply no earlier than the 2023 distribution year. The notice didn’t clearly say that RMDs are waived for 2021 and 2022, but it did say that no penalties will apply for failure to take RMDs in 2021 or 2022. Anyone who paid a penalty for not taking a 2021 RMD can apply for a refund.

How do you know if you fall under the 10-year rule?

The 10-year rule applies if you are an individual who inherited a retirement account from someone who 1) died after 2019 so you are subject to the SECURE Act and 2) you are not an eligible designated beneficiary (EDB) (i.e. spouse, child of deceased owner who is under age 21, disabled or chronically-ill person, or a person not more than 10 years younger than the deceased account owner, i.e. sibling) who can take distributions over their lifetime.

Under the 10-year rule, you are now subject to annual RMDs if the decedent died after they were required to start taking RMDs during their lifetime (after their required beginning date (RBD), which is April 1 of the year after they turned age 72). Beneficiaries who inherit a retirement account from someone who wasn’t yet required to take minimum distributions during their lifetime don’t have to take any annual distributions during the 10-year period. They can wait until year 10 if they want to.

Roth IRAs are excluded from the annual RMD requirement but must still be fully distributed within 10 years. Since Roth IRAs can be distributed tax-free, there’s usually no sense in accelerating the distribution. Let it ride until the 10th year to maximize that tax-free compounding.

The 10-year rule under the SECURE Act severely shortened the stretch on these retirement accounts. That accelerates the income tax impact to individuals and certain trusts named as beneficiaries. From a financial perspective, it also accelerates how fast the cash comes out to the beneficiary, possibly sooner than the decedent would’ve wanted. These are all important considerations when planning for naming beneficiaries on your own retirement accounts.

This 10-year rule makes inheriting a Roth IRA even more valuable since there’s no tax crunch on the short distribution period. That’s especially valuable if certain qualified trusts are named beneficiary due to their compressed tax brackets. In this down market, it might be worth evaluating if a Roth IRA conversion makes sense for your situation, whether as consideration for your lifetime benefit or as an estate planning strategy. The value of the converted amount is taxable, so these lower market values either allow you to convert more or reduce the value of the account you wish to convert and thereby the tax.

With the SECURE Act and regulations that follow, the RMD rules continue to get more complicated instead of simpler. It’s often hard for many professionals to keep it all straight let alone the beneficiaries who inherit these accounts.

The Bonadio Group’s Estate & Trust team has years of advisory and tax experience. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.