Retirement savers have taken full advantage of IRAs to allow their nest eggs to grow on a tax-deferred basis. However, because traditional IRAs require the accountholder to pay tax when making withdrawals and because Roth IRAs maintain their tax-free status as long as one keeps assets inside the account,, many retirees don't end up fully drawing down their retirement accounts before they pass away.
The inheritance rules for IRAs were already complicated before a new law took effect in 2019. Now, just as many people thought they were coming to grips with the new rules for inherited IRAs, the Internal Revenue Service is throwing a curveball that could have massive implications for those who've recently inherited these retirement accounts.
What changed with inherited IRAs?
For those who inherited an IRA from someone who passed away in 2019 or earlier, several options were available. The simplest was something only surviving spouses could do: take the deceased spouse's IRA assets and move them into a new IRA in the surviving spouse's name. Thereafter, the assets would be treated the same way as the surviving spouse's own retirement savings .
Non-spouse heirs in 2019 and earlier could either take out all of the money from the account within a five-year period, or take required minimum distribution in small chunks over the remainder of their lifetimes. This latter “stretch IRA” option was based on life expectancy, with the result being that some heirs could keep inherited IRAs open for decades following the death of the original accountholder.
The new rules that took effect for heirs of those who passed away in 2020 or later eliminated the stretch IRA for most beneficiaries. Except for minor children, beneficiaries no more than 10 years younger than the accountholder, and those who are disabled or chronically ill per IRS rules, heirs couldn't take RMDs over the course of their lifetimes. Instead, they had to liquidate the inherited IRA by the end of the 10th year after the year of the original accountholder's death.
A new interpretation
Initially, most financial planners took the new 10-year rule at face value . The wording of the new law suggested that heirs could wait until the end of the 10th year following death before doing anything, as long as they then withdrew the full remaining amount of the IRA's value at that point.
However, new guidance from the IRS suggests that tax officials have a different view. Under this guidance, if the original accountholder had already started to take required minimum distributions from the IRA before death, then the inheriting beneficiary would also have to continue taking RMDs in addition to meeting the 10-year rule. In other words, an heir couldn't just wait until year 10 after death to start making withdrawals from the IRA. The heir would also have to take certain amounts out in years 1 through 9, with the specific withdrawal calculated in a manner consistent with the old stretch IRA rules. On the other hand, those who inherited IRAs from those who hadn't had to start taking RMDs would be able to wait until year 10 if they wanted to.
Are penalties coming?
The worst part of this new guidance is that it comes nearly three years after the new rules started to take effect. That means that many heirs who inherited IRAs since 2020 have thought they were following the rules correctly, but the new guidance would indicate that they might have been doing something wrong.
The stakes are potentially high. The penalty for failing to take an RMD when you were supposed to is a whopping 50% of the RMD amount. Some are hopeful that the IRS will not impose those penalties because of a reasonable position to the contrary, but that's no guarantee that the government will do the right thing.
Be careful out there
IRAs are useful vehicles for retirement savings, but they come with some unexpected traps. Being aware of the potential for these rules to change is essential to make sure you don't pay a big penalty on your inheritance.
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