The IRS recently clarified significant changes to the rules governing how non-spousal beneficiaries withdraw funds from inherited Individual Retirement Accounts (IRAs). These updates stem from the SECURE Act of 2019, with further clarifications in 2022 and 2024. Understanding these changes is crucial for both those planning their estates and their beneficiaries.
The 10-year rule: A major change for non-spousal beneficiaries.
Prior to the SECURE Act, non-spousal beneficiaries could “stretch” distributions over their lifetimes, minimizing the annual tax burden.
The SECURE Act introduced a 10-year rule for most non-spousal beneficiaries who inherit IRAs from someone who passed away after December 31, 2019. Under this new rule, the entire balance of the inherited IRA must be withdrawn within 10 years of the original owner’s death.
Required Minimum Distributions (RMDs) during the 10-year period.
A key distinction recently confirmed in the 2024 Final Regulations is that non-spousal beneficiaries may have to take annual RMDs depending on when the original account owner died. Here’s how it works:
- If the original account owner died before their Required Beginning Date (the date by which they must have started taking RMDs), beneficiaries are not required to take RMDs during the 10-year period. They simply need to withdraw the entire account balance by year 10.
- If the original account owner died on or after their Required Beginning Date, beneficiaries must take annual RMDs in addition to fully distributing the account by the end of the 10th year. Note that RMDs under this rule do not start until 2025, with no penalties for missed distributions between 2021 and 2024.
Tax considerations for beneficiaries.
The 10-year rule has important tax implications, particularly for traditional IRAs. Since traditional IRAs are funded with pre-tax dollars, withdrawals are taxed as ordinary income. Taking large distributions within a limited timeframe could push beneficiaries into higher tax brackets.
For Roth IRAs, the withdrawals remain tax-free if the account was opened for at least five years. However, depleting a Roth IRA within 10 years may affect long-term financial planning, especially if beneficiaries were counting on continued tax-free growth.
Exceptions to the 10-year rule.
Certain “Eligible Designated Beneficiaries” can continue to take distributions over their lifetime, exempt from the 10-year rule. These individuals include:
- Minor children of the original account owner (though the 10-year rule begins once they reach age 21).
- Individuals who are chronically ill or disabled.
- Beneficiaries who are within 10 years of age of the deceased account owner.
Financial planning strategies for managing Inherited IRAs.
Given the potential tax burden and new rules, non-spousal beneficiaries and IRA owners should consider various strategies:
- Tax-efficient withdrawals: Beneficiaries should weigh the benefits of spreading withdrawals evenly across the 10 years versus taking larger distributions in lower-income years. The goal is to avoid being pushed into higher tax brackets if possible.
- Roth conversions: IRA owners may want to convert their traditional IRA to a Roth IRA before their death. This strategy shifts the tax burden to the present and allows the beneficiaries to withdraw tax-free in the future.
- Estate planning adjustments: IRA owners should revisit their estate plans to factor in these new regulations. Diversifying assets and considering non-IRA accounts for inheritance can provide heirs with more flexibility and fewer tax complications.
Navigating the new IRA rules.
The recent IRS updates represent a significant shift in how non-spousal beneficiaries handle inherited IRAs. While the 10-year rule simplifies the distribution timeline, it introduces potential tax challenges that require careful planning. If you have any questions or need additional help making informed decisions about your estate or inheritance, do not hesitate to reach out to us, your estate attorney or your CPA.
Disclaimer: This material is for informational purposes only and should not be considered financial, tax, or legal advice. Always consult with a qualified professional regarding your specific situation. All investment strategies involve risk, and there is no assurance that any strategy will achieve its intended results.