People who inherited retirement accounts in recent years finally have guidance from the Internal Revenue Service on how to drain their accounts. A few strategies can help you avoid handing over more than necessary to the IRS.
The maddeningly confusing rules on inherited IRAs and other retirement accounts resemble a Rube Goldberg contraption. But the IRS has finally cleared up some aspects on required minimum distributions, or RMDs. Play it well and you could you avoid a huge tax bill.
In guidance issued on July 18, the IRS confirmed that most nonspouse beneficiaries must make annual withdrawals from their inherited IRA or 401(k)s, provided that the original account owner had already begun taking RMDs. Think of RMDs like a faucet, says Ed Slott, an IRA expert. “Once the faucet is turned on, you can’t turn it off.”
Heirs had been in limbo since the Secure Act of 2019 eliminated the “stretch IRA” for most nonspouse beneficiaries who inherited an account on or after Jan. 1, 2020. This rule had permitted adult children and others to stretch their withdrawals over their own life expectancy, allowing for more growth in the inherited account. Lawmakers thought that was too big of a tax break and killed it to accelerate revenue from inherited accounts.
In place of the stretch, the law requires most nonspouse heirs to drain the account they inherited within 10 years after the year of the original owner’s death. But it didn’t specify the pace for pulling money out. Most tax experts initially assumed that heirs could wait until the end of the tenth year to take out all the money.
In early 2022, the IRS proposed stricter rules that would apply to those who inherited an IRA from a person who had already begun taking RMDs; in that case, they must continue to take RMDs on an annual schedule. This proposal caused so much confusion and controversy that the IRS waived the RMD requirement through this year.
The IRS’ new guidance affirmed that most nonspouse heirs have to start their RMDs in 2025, if they haven’t already. The penalty for not taking RMDs is 25% of the amount that should have been withdrawn. Here’s what you need to know.
What if I inherited an IRA before 2020?
The new regulations do not apply to you. You are exempt from them due to the previous stretch IRA rules that were in effect before the legislation was passed.
What happens if I received an IRA from my deceased spouse?
None of these modifications affect spouses, who have much greater leeway when they inherit IRAs. They have the option to transfer their deceased spouse’s IRA into their own retirement plan or maintain it as an inherited account. In either case, they can extend withdrawals according to their life expectancy rather than being confined to a 10-year period.
Are there any other beneficiaries who can still stretch RMDs over their own lifetimes?
Certainly. Widows or widowers fall under a classification of specific inheritors known as " eligible designated beneficiaries." This grouping also encompasses individuals who are not older than ten years compared to the initial IRA holder, people with chronic illnesses or disabilities, and offspring—specifically minors rather than grandkids—of the original account owner.
The final rule clarifies that minor children can include stepchildren and foster children. However, once the heirs reach 21, they become adults and the 10-year clock starts.
What happens if I inherit a traditional IRA after 2019 from an individual who was already making required minimum distributions?
You must begin taking RMDs in 2025 if you haven’t already. You don’t need to take retroactive RMDs for the years when the requirement was waived. However, the intervening years do count toward your calculation. To determine next year’s RMD, use IRS Table 590-B to find your life expectancy factor for the year after the account owner’s death, Slott says.
Suppose you received an IRA inheritance in 2020 when you were 50 years old. By 2025, you would calculate the account balance from the previous year by dividing it by 31.3, which represents your life expectancy factor for having been 51 in 2021, the year following the time you took possession of the inherited account.
The life expectancy factor approach is used for years one through nine. In year ten, however, you have to withdraw the leftover balance.
What is the appropriate amount for me to withdraw?
Keep an eye on potential tax implications when withdrawing just the minimal amount mandated up until year nine. This might result in a substantial remaining sum to be cleared out in the tenth year. All withdrawal amounts contribute directly to your taxable income for each respective year. Spreading out these withdrawals relatively evenly throughout the designated timeframe can reduce the likelihood of facing a significant tax liability during the last disbursement in year ten. Pay attention to your current tax rate and try not to draw funds that would push you into a higher bracket if at all feasible.
An additional consideration is that the present tax rates are set to lapse by the conclusion of 2025. Unless Congress intervenes, the lower brackets established under theTax Cuts and Jobs Act of 2017will return to their previous values. Opting for increased withdrawals now might help reduce your overall taxes.
One exception is if you plan to retire during the distribution period, says Evan Potash, executive wealth management advisor with TIAA in Newtown, Pa. If you know you’re going to drop down into a lower tax bracket soon, it could make sense to take only the minimum required withdrawals until you do so.
What if I inherited an IRA after 2019 from someone who hadn’t begun taking RMDs?
You don’t need to take annual RMDs, but you still have to empty the account by the end of the tenth year following the original account holder’s death. It might still make sense to withdraw some each year, to stagger your tax liability and take advantage of today’s lower rates.
What if I inherited a Roth account?
Roth accounts aren’t subject to RMD requirements but still must be drained by the end of the tenth year after the original owner’s death. Heirs don’t owe income taxes on withdrawals, so if you don’t need the money, consider leaving it alone to allow for maximum growth until year 10.
Send an email to Elizabeth O'Brien at elizabeth.obrien@barrons.com
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