The IRS is proposing changes to inherited IRA rules that could have significant tax implications to you if you’ve inherited an IRA (or Individual Retirement Account) from a family member.
Essentially, if you’ve inherited an IRA from someone who wasn’t your spouse, like a family member, you have 10 years from the date of their passing to deplete the funds in that account via required minimum distributions, or RMDs. This is called the 10-year rule. Before the Secure Act, inheritors of an IRA were able to stretch out taking out money from the inherited IRA over the course of their lifetime, and minimized taxes by keeping the funds invested. The details are still being finalized by the IRS.
“It’s confusing what’s been done because it appears to be retroactively dated,” says Natalie Bullen, a financial advisor and CEO of Unapologetic Wealth Management.
Here’s what you need to know about the proposed changes to inherited IRA rules and how to prepare if you’ve inherited an IRA.
The Secure Act and What the IRS Is Doing
On Dec. 20, 2019, the Secure Act — Setting Every Community Up for Retirement Enhancement Act — was passed by Congress and signed into law. It became effective on Jan. 1, 2020.
The Secure Act changed the date before which required minimum distributions must start. For example, if someone was born before July 1, 1949, the age they had to start taking RMDs from retirement accounts was 71 1/2. Now, anyone born after July 1, 1949, is required to begin taking these required minimum distributions at 72.
It also changed how and when inherited IRA funds must be distributed. As of January 2020, all funds from an inherited IRA must be fully withdrawn within 10 years of the original account owner’s passing if the original IRA owner died on or after Jan. 1, 2020. The Secure Act eliminated the ability to stretch withdrawals over a beneficiary’s lifetime.
“If you had inherited a retirement account from somebody who was already past the required beginning date, you were able to stretch the distributions over the rest of your life—based on your life expectancy,” says Beau Henderson, a retirement specialist and CEO of Rich Life Advisors. “The Secure Act closed that loophole, stating you have to clear out the accounts in a 10-year window.”
The Proposed Changes to Inherited IRA Rules
Financial experts initially interpreted the Secure Act as not enforcing “annual” minimum distribution requirements for non-spouse beneficiaries. That means you could let the money sit in an inherited IRA for 10 years without needing to distribute the funds.
The proposed changes, however, state that if an account holder dies after they had started taking their RMD, non-spouse beneficiaries would need to withdraw funds each year, from years one to nine, until the account is depleted.
The changes would impact all beneficiaries who inherited an IRA from a non-spouse who was subject to RMDs on their date of death and passed away after Dec. 31, 2019. The changes wouldn’t apply between spouses or to beneficiaries of individuals who died (at any age) before January 2020.
If you’ve inherited a non-spouse beneficiary, you should talk to a financial professional and see what options you have available to you.
The Potential Impact of the Proposed Inherited IRA Rule Changes
Assuming the proposed changes are passed, which may be as early as this fall, some beneficiaries may have already missed a required distribution and incurred penalties. The penalty for a missed required distribution is typically 50% of the missed RMD. The IRS has held public hearings about the proposed changes, so there’s not a definite answer as to when these changes might pass.
“The new proposed rules affect people who would have been required to take out an RMD in 2021, possibly accruing a 50% penalty,” says Henderson.
However, Henderson says there’s still hope beneficiaries won’t be penalized if the change is enacted: “It would be unlikely that the IRS could enforce the 2021 distributions because nobody knew the rules. The penalty will likely be waived if the new rules are enacted.”
In the past, a non-spouse beneficiary may have had decades to exhaust an IRA and spread out the potential tax liability. Under the Secure Act and these proposed changes, a beneficiary has 10 years to fully deplete the inherited IRA, and those distributions are counted as ordinary income. Non-spouse beneficiaries would be required to distribute the funds in a way that could add significant taxable income each year, possibly even pushing them into a higher tax bracket.
“Right now, it’s smart for anyone advanced in age to let their potential beneficiaries know what’s happening,” says Bullen. “You do not want to find out at this point if you’re 28 that your grandfather has left you $500,000 in an inherited IRA that you’re now tasked with depleting in 10 years (as ordinary income) via a required minimum distribution.”
What Should Beneficiaries Do Now?
Bullen notes that anyone considering potential non-spouse beneficiaries should talk to a financial professional and see if there might be opportunities other than leaving this money directly to them in an inherited IRA.
In the short term, it’s worth noting that these proposed changes would need to be passed by Congress and signed into law. But it would be wise to consult a financial or tax professional to go over the potential implications. Non-spouse beneficiaries may have to wait and see if the proposed changes pass and what happens next.