IRS Wants To Change Distribution Rules for Non-Spouse Inherited IRAs: What are the Tax Impacts?
Figuring out the most efficient way to navigate the tax impact of inheriting individual retirement accounts has become more complicated since the Internal Revenue Service issued proposed new rules in February. Both a Forbes contributor Kristin McKenna and The Wall Street Journal recently wrote articles about this topic.
The WSJ points out that the rules on inherited IRAs were most recently changed in the 2019 Secure Act, which introduced a new 10-year payout rule for inherited accounts. The previous rule said those who inherited an IRA, Roth IRA or 401(k) could spread out withdrawals over their lifetime.
Many tax advisors thought the new 10-year rule language meant that these heirs could wait until the 10th year before taking any payouts, and that is what the IRS said in a May 2021 revision to Publication 590-B, a 69-page guide to IRA distributions. And Forbes also stated that starting in 2020, instead of stretching withdrawals over your lifetime, most investors inheriting an IRA from a parent were subject to a new “10-year rule.” This meant annual required minimum distributions (RMDs) were out. Instead, beneficiaries had to take the money – in full – in 10 years.
It now gets a little more confusing
But in February of 2022, the IRS proposed new changes, and if enacted, some inherited IRA heir beneficiaries will need to take RMDs (annual withdrawals in cases where the original owner died on or after his required beginning date for taking distributions) again and could face big penalties.
The annual distributions are based on a formula that takes into account the IRA balance and the age of the recipient. The new guidance also applies to 401(k)s, but with those plans, employers often already set even more restrictive payout rules.
According to some accountants “payouts from a traditional inherited IRA are taxed like wage income. The new guidance means that many Americans inheriting an account will inherit it during their working life, and will therefore pay a much larger tax bill.”
IRS proposes changes to Secure Act inherited IRA RMD rules
Unless a non-spouse beneficiary qualifies for an exception¹, previous guidance stipulated that funds from an inherited 401(k), IRA, 403(b), or other qualified retirement plans (including Roth IRAs) must be taken in 10 years following the year of death. Original guidance indicated disbursements within this 10-year window were optional.
Now, the new proposed regulations from the IRS further complicate the matter by changing previous guidance. For some, this comes years after the death took place.
Changes that would affect individuals who inherited an IRA from a parent
The central change the IRS is proposing would impact beneficiaries who inherited an IRA from a non-spouse who were subject to RMDs on the date of death and passed away after 12/31/2019.
Another key aspect that the Forbes article points is that the 2019 Secure Act changed is the required minimum distribution age. Individuals born before July 1, 1949, will retain an RMD age of 70 1/2. People born on or after this date saw their required beginning date increase to age 72.
The new IRS proposal would require individuals who inherited a retirement account from decedents meeting these criteria to take RMDs during this 10-year period and fully disburse funds by the end of 10 years. Withdrawals during years one through nine would use the old stretch IRA rules.²
Payouts from a traditional inherited IRA are taxed like wage income.
Taxpayers can deal with the new law and guidance by calculating the necessary amount each year. Or, they can cash out in the first year and pay one tax bill. Taxpayers who fail to take a required distribution are hit with a tax penalty that is equal to half the amount that should have been taken out.
Assuming the changes pass, some beneficiaries will have missed a required distribution. Typically, the penalty for such a mistake is 50% of the missed RMD! It’s probable that the IRS would waive penalties as the announcement only came in February 2022 and still isn’t law. So beneficiaries who should have taken an RMD in 2021 wouldn’t have had any opportunity to do so.
The WSJ article also mentions that spouses and certain categories of heirs including disabled individuals can still spread out the withdrawals over their lifetime. And inherited Roth IRA owner acct’s don’t have to take payouts until the end of the 10-year period because Roth IRAs don’t have annual payout requirements.
One example in the WSJ article points out that a lawyer in Melville, N.Y., has a client whose mom died in her 90s in 2021. The client left two traditional IRAs, one valued at $105,000 and the other at $35,000, to her four grandchildren.
This meant there were then eight separate IRAs, with each grandchild needing to calculate their own life expectancy, and take different distributions in years one to nine. The balance would be taken in the 10th year, under the proposed rules. Ultimately the grandchildren didn’t want to deal with the hassle and decided to take the lumpsum instead.
There has been lobbying by some industry groups including the Investment Company Institute and the American Institute of Certified Public Accountants, urging the IRS to remove the additional annual distribution requirement or temporarily waive penalties for people who inherited money since 2019 but haven’t taken distributions.
One taxpayer put it succinctly: “Just leave it the way it was plainly written as this is causing too much confusion.”
The IRS says that it is reviewing comments and will respond to them in the final rules. The proposed regulations represent the IRS’s view of the law. One lady named Margaret Rolo, of Rancho Mirage, California, who inherited an IRA worth $400,000 from her mom hasn’t touched it since her passing in 2020, telling the journal “I read about the change and started panicking about the penalties.”
Ms. Rolo says her financial adviser has told her to hold out to see how the final IRS rules play out. Taking a distribution in 2021, tacked onto a high-income year, would have meant a large tax bill, says Ms. Rolo.
Peter Brady and Steven Bass, economists at the Investment Company Institute, found in a recent paper analyzing pension payouts that 1.6 million taxpayers totaled $9.2 billion in 2010. These numbers are most likely much higher today given the population has aged and the total value of IRA assets has increased from $5 trillion in 2010 to $13.2 trillion.
David Donnelly, a CPA with Carr, Riggs & Ingram in Houston.“the IRS could potentially waive penalties for missed 2021 distributions, and then require taxpayers to take out the balance over the remainder of the 10-year period.”
The IRS could also make taxpayers make up missed distributions, or they could go back to the previous guidance.
Mr. Donnelly told the journal “It will depend on how agitated Congress gets about this.”
For 2020 heirs who skipped a 2021 distribution, Mr. Jones says they should play it safe and make a remedial distribution, file a Form 5329 to report the shortfall, and attach a penalty waiver request that explains why they had reasonable cause for the missed distribution.
What the IRS proposal wouldn’t change
The new guidelines currently wouldn’t alter existing post-Secure Act guidance for beneficiaries who inherited a retirement account from a non-spouse who died before reaching their RMD age. Changes wouldn’t apply to individuals who died (at any age) before 2020 or between spouses.
The new guidance also wouldn’t apply to beneficiaries of Roth IRAs, as Roth IRAs don’t have RMDs (Roth 401(k)s, do). However, non-spouse beneficiaries would still need to take all the funds within the 10-year window.
What should beneficiaries do now?
The Forbes article author feels that “the changes to inherited IRAs discussed above seem likely to pass. But until that happens, most individuals may want to consider a wait-and-see approach.” If the inherited RMD distribution rules do change, make sure to consult your financial and tax professional to assess the implications and evaluate any potential planning opportunities. Particularly for beneficiaries inheriting a large retirement account in prime earning years, the tax impact may be significant.
For 2021 heirs who have to take their first distribution this year, they could hold off until closer to year-end to see whether the IRS or Congress makes changes.