What is the 10-Year Rule for Inherited IRAs, and How Does It Affect Your Retirement Savings?
Estate planning is an important practice for anyone who wishes to have control over the distribution of their assets and protect their loved ones from unnecessary financial burdens and legal complexities. One significant aspect of estate planning is considering what happens to retirement accounts, such as the Individual Retirement Account (IRA), after the account holder’s passing. Inherited IRAs can significantly impact the beneficiary’s financial future. If managed wisely, an inherited IRA can provide long-term financial security, tax-advantaged growth, and a consistent income stream for the beneficiary. However, the rules governing inherited IRAs can be complex, and the tax implications can vary based on the beneficiary’s relationship to the original account holder. Recent changes in laws, such as the inherited IRA 10-year rule, have also impacted these accounts.
A financial advisor can help you understand these latest rules and regulations concerning inherited IRAs. This article will discuss some of these rules and how they can impact different types of beneficiaries. It will also discuss strategies for individuals to navigate potential tax implications.
What is an inherited IRA?
An inherited IRA is created when an IRA account is transferred to a designated beneficiary upon the original account holder’s death.
As of January 1, 2023, the age for Required Minimum Distributions (RMDs) from an IRA is 73 years. If a spouse inherits an IRA, they have specific rules governing when they must start taking RMDs. The spouse can treat the inherited IRA as their own by rolling it over into their account or designating themselves as the account owner. In this case, the spouse’s RMDs will begin by the end of the year after the original account owner’s death or when the spouse reaches the age of 73, whichever comes later.
Apart from spouses, an IRA can also be inherited by a child, grandchild, or any other individual chosen by the account holder.
The Inherited IRAs have undergone significant transformations in recent years. There have been several legislative changes aimed at enhancing retirement security. The SECURE Act, enacted on January 1, 2020, and the more recent bipartisan bill, “Securing a Strong Retirement,” introduced a series of modifications to defined contribution retirement plans, particularly impacting inherited IRAs.
What is the 10-year rule for inherited IRAs?
The SECURE Act, which was signed into law on December 20, 2019, ushered in a notable shift in the treatment of inherited IRAs for non-spousal beneficiaries. Before this legislation, beneficiaries who were not spouses of the account holder had the option to stretch out IRA distributions over their lifetimes, allowing for potentially tax-advantaged growth over many years. However, the SECURE Act implemented a 10-year withdrawal rule. According to this rule, non-spousal beneficiaries are required to withdraw the entire inherited IRA balance within ten years from the original account holder’s death.
What are some of the exceptions to the 10-year rule for inherited IRAs?
While the 10-year withdrawal rule applies to most non-spousal beneficiaries, the SECURE Act also introduced exceptions to this rule.
The following beneficiaries can still stretch out IRA distributions over their lifetimes:
1. Spouses
The inherited IRA distribution rules have not changed for spouses. Spouses who inherit an IRA are still eligible for the lifetime stretch option, allowing them to continue taking distributions over their life expectancy.
2. Minor children
Minor children of the deceased account holder can stretch IRA distributions until they reach the age of majority. Afterward, they must adhere to the 10-year withdrawal rule. Do note that the age of majority differs from state to state and is commonly between ages 18 and 21.
3. Disabled or chronically ill beneficiaries
Beneficiaries who meet specific criteria for disability or chronic illness are exempt from the 10-year rule. This means they can utilize the lifetime stretch strategy and withdraw funds throughout their lifetime as they see fit.
4. Beneficiaries close in age to the account holder
Beneficiaries who are within ten years of the age of the original account holder (younger or older) may continue with the lifetime stretch option.
How the 10-year rule for Inherited IRAs impacts beneficiaries
One crucial aspect when understanding how the 10-year rule for inherited IRA impacts beneficiaries is the Required Beginning Date (RBD). RBD is the date by which the original IRA owner must begin taking RMDs from their retirement account. Typically, the RBD is April 1st following the calendar year in which the account owner reaches the age of 73, 72, or 70.5 years.
Three scenarios to help you understand how the 10-year rule for Inherited IRAs can impact beneficiaries based on the account holder’s RBD:
1. When the account holder dies before their RBD
If the account holder dies before their RMD, the 10-Year rule comes into play for both designated and Eligible Designated Beneficiaries (EDBs). Designated beneficiaries include the following:
- Individuals designated as the beneficiary of an IRA
EDBs include the following:
- Spouse of the deceased account holder
- Minor child of the deceased account holder
- Disabled or chronically ill individual
- An individual who is not more than ten years younger than the IRA owner or plan participant
The 10-Year rule states that distributions are optional for the first nine years after the participant’s death, but the entire account balance must be fully distributed by the end of the 10th year. Designated beneficiaries, who are not EDBs, must adhere to this rule strictly. However, EDBs have an additional option known as the life expectancy option. Under this option, EDBs can take distributions over their entire life expectancy, starting by December 31, following the year the account holder dies.
For minors who are EDBs, the 10-year rule and life expectancy rule can be combined. Until the minor reaches age 21, distributions are taken over their life expectancy. Afterward, the account must be fully distributed by the end of the 10th year following the child’s 21st birthday.
2. When the account holder dies on or after their RBD
In this scenario, a designated beneficiary must adhere to the 10-Year rule, which mandates taking annual RMDs over their life expectancy starting by December 31 of the year following the participant’s death. The entire account must be fully distributed by December 31 of the tenth year following the account holder’s death.
For EDBs, who are minors at the time of the account holder’s death, they must take distributions over their life expectancy, and the account must be fully distributed by the end of the 10th year after they reach age 21.
3. When the EDB dies
This rule applies to a successor beneficiary who inherits a retirement account from an EDB who had been taking distributions over their life expectancy. The designated beneficiary must have inherited the retirement account before 2020, taken distributions under the life expectancy method, and died after 2019 to qualify for this rule.
The successor beneficiary must continue taking annual distributions over the life expectancy that applied to the EDB. Additionally, the account must be fully distributed by the end of the 10th year following the year of the EDB’s death.
SPONSORED WISERADVISOR
3 strategies that can help you save tax on an inherited IRA
1. Spread out your RMDs to manage tax liability
One strategy that beneficiaries may consider is taking equal required minimum distributions from inherited IRAs. Instead of withdrawing the entire balance in a lump sum or taking irregular distributions, they can calculate and withdraw an equal amount each year over the 10-year period. This strategy will allow beneficiaries to maintain a consistent income stream over the 10-year period and spread out their tax liability evenly.
Suppose beneficiaries have lower overall income due to factors like job changes, retirement, or other life events in some years. In that case, they can consider taking larger distributions from the inherited IRA and vice versa and balance out their income and tax by aiming to fall within a lower tax bracket.
2. Convert your Traditional IRA to a Roth IRA
Beneficiaries can consider converting a portion of the inherited Traditional IRA to a Roth IRA, depending on their tax situation. Although they will have to pay taxes on the converted amount, it can be advantageous if they anticipate being in a higher tax bracket in the future. Roth IRAs offer tax-free withdrawals in retirement, potentially saving money in the long run.
3. Defer your taxes with annuities
Beneficiaries can consider moving the inherited IRA funds into an annuity. This can help them defer taxes and establish a steady stream of income. Annuities can also be a great way to grow the money potentially.
Other lesser-known facts to keep in mind concerning inherited IRAs
1. IRA heirs may face issues with creditor protection
According to the Supreme Court Ruling, an inherited IRA account does not offer the same protection from creditors in bankruptcy or lawsuits as regular IRA and 401(k) accounts. This means heirs may face issues with creditor protection if they inherit an IRA or 401(k) account. Therefore, it is important to explore other estate planning vehicles, such as a trust, that might be a more suitable option to protect assets from creditors. You may also consider consulting a financial advisor or estate planning professional to make informed decisions.
2. There might be limitations with commingling inherited accounts
Non-spouse beneficiaries cannot blend inherited IRA and 401(k) balances with their retirement accounts. Moreover, combining inherited accounts with personal accounts is also not allowed. Having said that, there are some exceptions to combining similar inherited accounts.
If multiple IRAs or 401(k)s are inherited from the same person, beneficiaries may be able to combine account balances of the same type. For example, this may be possible in the case of combining two inherited traditional IRA accounts into one. But it is important to note that the process can be complex. It requires clear communication with the custodian and guidance from a qualified financial or tax advisor.
3. You might be able to waive your excise tax
The Internal Revenue Service (IRS) has provided an automatic waiver of the excise tax for beneficiaries who failed to take their RMDs for the years 2021 and 2022 under two situations:
- When the account holder dies on or after their RBD
- When the EDB dies
This waiver can help ease potential tax burdens for beneficiaries dealing with the complexities of inherited IRAs.
4. Some beneficiaries might be able to waive their penalties
On July 14, the IRS issued Notice 2022-54, providing welcome relief to certain beneficiaries of inherited retirement accounts who missed RMDs in 2023. This notice comes as a response to the 2022 proposed guidance, which outlined penalties for beneficiaries who failed to take the required distributions from inherited retirement accounts.
Under the 2022 proposed guidance, beneficiaries who did not take their RMDs were subject to a substantial penalty of 50% of the amount that should have been withdrawn. However, the recent notice announced a reduced penalty of 25% for missed RMDs starting in 2023. This reduction in the penalty aims to ease the financial burden for beneficiaries who inadvertently overlooked or were unaware of the RMD requirements.
To conclude
Estate planning can be complex, and while an IRA can be a great way to financially secure your loved ones in your absence, it is important to stay updated with the rules and regulations concerning them. Account holders and beneficiaries should carefully consider their options and plan accordingly to maximize the benefits of an inherited IRA. At the same time, it is also critical to avoid potential penalties and tax implications.
With the recent changes made to inherited IRAs, navigating the retirement and estate planning landscape can get a little confusing. However, reaching out to a financial advisor can help you decipher how these rules impact your unique situation. Use the free advisor match service to connect with financial advisors who can help. All you need to do is provide information on your financial needs, and the matching tool will connect you with 1-3 suitable vetted financial advisors.