The landscape of inherited Individual Retirement Accounts (IRAs) has undergone significant changes in recent years with the introduction of the SECURE Act in 2019 and its subsequent enhancement, SECURE 2.0. Below, we will outline the current rules governing inherited IRA distributions and highlight the recent changes.
A Brief Look Back: Pre-2019 Inherited IRA Rules
Before the SECURE Act, beneficiaries of inherited IRAs could stretch distributions over their life expectancies, potentially allowing for decades of tax-deferred growth. This strategy, known as the “stretch IRA,” provided significant tax benefits and was a popular estate planning tool. These rules still apply to spousal beneficiaries and those who inherited IRAs before 2020.
The New Landscape: SECURE Act and SECURE 2.0
The SECURE Act of 2019 and SECURE 2.0 passed in 2022, brought substantial changes to the inherited IRA rules for accounts inherited after December 31, 2019. The most significant change was the elimination of the “stretch IRA” provision for most non-spouse beneficiaries, replacing it with a 10-year distribution rule. SECURE 2.0 further refined these rules, particularly regarding Required Minimum Distributions (RMDs) within the 10-year period.
The SECURE Act created new categories of beneficiaries:
Eligible Designated Beneficiaries (EDBs)
EDBs include:
- Surviving spouses
- Minor children of the account owner (until they reach the age of majority)
- Disabled individuals
- Chronically ill individuals
- Individuals not more than 10 years younger than the account owner
- Some see-through trusts benefiting the above individuals
EDBs can still use the life expectancy method for RMDs, similar to the prior rules. More options are available depending on whether or not the account owner had reached their required beginning date (discussed below).
Non-Eligible Designated Beneficiaries
Most non-spouse beneficiaries who don’t qualify as EDBs are subject to the new 10-year rule. Under this rule, the entire inherited IRA balance must be distributed by the end of the 10th year following the year of the account owner’s death. In some cases (discussed below), these beneficiaries will also be subject to annual required distributions.
Inheriting Before vs. After the Required Beginning Date (RBD)
The RBD is the date by which an IRA owner must start taking RMDs from their traditional IRA. For most individuals, the RBD is April 1 of the year following the year they turn 73 (age 75 for those born on or after January 1, 1960). For inherited IRAs, the distribution rules differ slightly depending on whether the original account owner died before or after their RBD:
- If the account owner died before their RBD:
– EDBs can take distributions based on their life expectancy, or elect to use the 10-year rule without annual RMDs.*
– Non-EDBs must empty the account by the end of the 10th year following the year of death. No annual minimum distributions are required.
- If the account owner died on or after their RBD:
– EDBs must take annual RMDs based on the longer of their life expectancy or the deceased owner’s remaining life expectancy.*
– Important update for Non-EDBs. Starting in 2025, non-EDBs must take annual RMDs in years 1-9 based on the longer of their life expectancy or the deceased owner’s remaining life expectancy, AND must empty the account by the end of the 10th year.
*Note that company retirement plans may have more restrictive rules.
Non-Designated Beneficiaries: Trusts and Estates
If the beneficiary is a non-designated beneficiary, such as an estate, charity or certain types of trusts, the distribution rules are as follows:
– If the account owner died before their RBD, the 5-year rule applies. The entire account must be distributed by December 31 of the fifth year following the year of death.
– If the account owner died on or after their RBD, distributions must be taken over the deceased owner’s remaining life expectancy.
Tax Implications for Beneficiaries Subject to the 10-Year Rule
Taking no distributions or only RMDs from an inherited IRA for the first nine years followed by a balloon distribution in the 10th year can have significant tax implications. While this approach maximizes tax-deferred growth and may have minimal or no tax impact in the early years, it can lead to a substantial tax burden in the final year. The large distribution in year 10 could potentially push you into a higher tax bracket, increase your marginal tax rate, and impact various tax credits, deductions, and benefits. It might also affect Social Security taxation, Medicare premiums, and potentially trigger the Alternative Minimum Tax. This strategy could be beneficial if you expect to be in a much lower tax bracket or have significant deductions in the 10th year, or if you’re planning to move to a lower-tax state. However, it carries the risk of higher overall taxation compared to more balanced distribution strategies outlined below.
Tax Planning Strategies
When planning the timing of your distributions, it’s important to consider your current and projected future tax brackets. If you anticipate being in a lower tax bracket in certain years within the 10-year period, it may be advantageous to take larger distributions in those years. For example, if you’re planning to retire in a few years, you might delay larger distributions until after retirement when your overall income (and tax rate) is likely to be lower.
Another strategy is to “bracket fill” each year. This involves taking distributions that bring your taxable income to the top of your current tax bracket, but not into the next higher bracket. This approach can help you avoid a large tax hit in the final year when you must distribute the entire remaining balance. It’s particularly important to plan for this final distribution, as it could potentially push you into a much higher tax bracket if not managed carefully.
Keep in mind that life events can significantly impact your tax situation. Major changes such as marriage, divorce, buying a home, or starting a business can all affect your taxable income and deductions. To the extent that you can anticipate these events, you may be able to adjust your distribution strategy accordingly. For instance, if you’re planning to make a large charitable donation in a particular year, that might be an opportune time to take a larger distribution from the inherited IRA, as the charitable deduction could help offset the increased income.
The rules governing inherited IRAs have become increasingly complex. It’s crucial for both account holders and beneficiaries to understand these rules to make informed decisions about estate planning and distribution strategies. As always, consulting with a qualified financial advisor or tax professional is recommended to navigate these complexities and optimize your inheritance strategy.