The SECURE Act, signed into law in 2019, brought significant changes to the rules regarding inherited individual retirement accounts (IRAs). Prior to 2020, beneficiaries of traditional IRAs could stretch out their withdrawals over their life expectancy, minimizing their tax bill. However, the SECURE Act put an end to this tax-saving strategy for most non-spouse heirs who inherit a traditional IRA from someone who died on or after January 1, 2020.
Now, non-spouse beneficiaries have two options when it comes to inherited IRAs. They can either take a lump sum distribution and pay taxes on the entire amount, or they can transfer the money to an inherited IRA and deplete it within 10 years after the death of the original owner. For example, if an individual inherited an IRA in 2020, they would need to clean out the account by December 31, 2030.
Initially, there was some confusion about when non-spouse beneficiaries needed to deplete their accounts. Tax experts believed that beneficiaries could wait until year 10 to take required minimum distributions (RMDs) from the inherited IRA. However, the IRS issued guidance in early 2022 stating that RMDs must be taken based on the beneficiary’s life expectancy in years one through nine, with the account needing to be fully depleted by the end of year 10. This guidance was aimed at non-spouse beneficiaries whose original owners were required to take RMDs but had not started them. If the original owner had not begun RMDs, beneficiaries could take withdrawals at any time during the 10-year period.
To address confusion surrounding this guidance, the IRS waived penalties for failing to take an RMD from an inherited IRA in tax years 2021 through 2024. However, the IRS recently issued final rules stating that beneficiaries must start taking RMDs next year and fully deplete the account within 10 years of the original owner’s death. Failing to take a distribution can result in a penalty of 25% of the amount that should have been withdrawn. This penalty may be reduced to 10% if the missed RMD is made up within two years.
It’s important to note that the 10-year rule also applies to inherited Roth IRAs, but with a key difference. Withdrawals from inherited Roth IRAs are not subject to taxes, and beneficiaries are not required to take RMDs. If beneficiaries can afford to wait until year 10 to deplete the account, they can enjoy over a decade of tax-free growth.
Spouses who inherit an IRA are not subject to the 10-year rule. They have the option to roll the money into a new or existing IRA and can postpone withdrawals until they reach the age at which they must take RMDs, which is currently age 73.
The impact of these rules will be felt by millions of Generation X, millennial, and Gen Z adult children who stand to inherit trillions of dollars in IRAs and other assets from their parents over the next 20 years. It is crucial for individuals in these age groups to understand the new rules surrounding inherited IRAs and plan accordingly.
In conclusion, the SECURE Act has brought about significant changes to the rules governing inherited IRAs. Non-spouse beneficiaries must now either take a lump sum distribution or deplete the account within 10 years. The IRS has clarified the timing of required minimum distributions for non-spouse beneficiaries and failure to comply can result in penalties. Roth IRAs follow the same 10-year rule, but beneficiaries enjoy tax-free growth. Spouses who inherit an IRA have more flexibility in terms of withdrawals. It is important for individuals who stand to inherit IRAs to familiarize themselves with these rules and plan accordingly for their financial future.
