If you inherited an individual retirement account from
someone who died after 2019, a recent change in federal tax rules could affect
the manner in which you make withdrawals known as required minimum
distributions, or RMDs.
In 2020, the Internal Revenue Service began requiring most
new inheritors who aren’t spouses or minor children of the deceased to empty
the inherited retirement account over 10 years, rather than continuing to allow
those inheritors to stretch out withdrawals over their own expected lifetimes.
The IRS, however, didn’t indicate whether these inheritors had to make a
minimum withdrawal each year, and many people were confused about whether they
had to take annual amounts.
In May, however, the IRS made it clear in a rule revision
that while the new 10-year rule stays in effect, there is no requirement to
take an annual RMD during those 10 years. The inheritor can even withdraw the
full amount in the first year, or wait until the 10th year, thus giving the
assets more time, potentially, to grow. Here’s what the IRS said: “If the owner
died in 2020, the beneficiary would have to fully distribute the plan by
December 31, 2030. The beneficiary is allowed, but not required, to take
distributions prior to that date.”
To know if the 10-year rule and the recent change apply to
you, you have to know in which of two categories you fall according to the 2020
Secure Act (Setting Every Community Up for Retirement Enhancement). The act
says that individuals who inherit an IRA are considered either eligible
designated beneficiaries or designated beneficiaries. Each category has
different requirements for withdrawing funds from the inherited IRA when
turning 72 and starting to make RMDs. Note also that these rules apply not just
to traditional and Roth IRAs but also to defined-contribution plans for
employees, such as 401(k) plans, 403(b) plans and 457(b) plans. They don’t
affect defined-benefit plans.
“It’s confusing,” warns Sarah Brenner, director of
retirement education at Ed Slott & Co., a tax consulting firm in Rockville
Centre, N.Y. But here’s what you need to know.
1. Eligible designated beneficiaries
For eligible designated beneficiaries, the old rules from
before 2020 remain in effect. To be considered a member of this category, the
beneficiary must be a living person who fits into one of five classifications:
a surviving spouse, a minor child of the account owner but not a grandchild, a
disabled person, a chronically ill person or someone not more than 10 years
younger than the original IRA holder.
These individuals can still stretch, or spread out, annual
required payouts over their lifetime, based on the IRS life-expectancy tables.
A spouse beneficiary, moreover, can even delay taking RMDs from an inherited
IRA until the year in which the deceased person (known as the decedent) would
have had to begin doing so.
For some beneficiaries, that could mean many decades during
which the assets in the inherited IRA can grow on a tax-deferred basis.
Note that if a minor child inherits an IRA from a parent
under the new rules, that child is an eligible designated beneficiary and can
stretch out distribution—but only to a point. When that child “ages out” and
reaches the age of majority—18 or 21, depending on the state, or age 26 if
still in school—a different set of rules applies, those governing designated
beneficiaries.
2. Designated beneficiaries
It is a different, more-nuanced story for designated
beneficiaries, a category that includes most nonspouse beneficiaries such as
older children, grandchildren and others. Designated beneficiaries who
inherited before 2020 are grandfathered under the old rules and can still
stretch. But designated beneficiaries inheriting after that date don’t have the
ability to do that.
Instead, they must empty the entire account by the end of
the 10th year after the death of the original account holder. Any amount that
remains in the account after that is subject to a 50% missed-RMD penalty.
However, designated beneficiaries do have total flexibility
in choosing the amount, frequency and timing of withdrawals based on lifestyle
and tax-planning needs, as long as the account Is fully depleted by Dec. 31 of
the 10th year following the death. For instance, if you inherited an IRA in
2020 and were laid off in 2021, it may be advantageous to take a larger
withdrawal this year when you could be in a lower tax bracket.
A recently released revision of IRS Publication 590-B,
“Distributions from Individual Retirement Arrangements (IRAs),” which was
issued as a guide to preparing tax returns, made it clear that designated
beneficiaries don’t have to take RMDs in years one to nine. Voluntary
distributions of any amount can be taken during any year in the 10-year period.
Regulations that might provide further guidance to the new
rules are still to be written by the IRS, and that could take a long time. The
IRS says, though, that answers to many of the questions that have been raised
about inherited IRAs will arrive “soon.”
When making withdrawals from an inherited IRA, remember that
the decision is irrevocable. After a distribution is taken, it can’t be put
back.
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