Understanding New RMD Rules for Inherited Individual Retirement Accounts

For many holders of traditional individual retirement accounts, minimum distributions (RMDs) are a familiar concept. They provide a way for the government to collect taxes on tax-deferred accounts, and investors who fail to make RMDs and pay taxes on them can face IRS penalties.

Recent legislation has brought many changes to RMD rules, causing some confusion. One point that’s been unclear: Are RMDs required for non-spousal inherited traditional IRAs? The IRS has finally answered that question: in many cases, yes.

As with most financial matters, the details make all the difference.

The SECURE Act and the “stretch IRA”

The original SECURE Act of 2019 and the SECURE Act 2.0 of 2022 brought a long list of changes to retirement savings plans that affected many Americans and kept financial advisors busy.

The SECURE Act 2.0 raised the beginning age for RMDs to 73 as of January 1, 2023. Investors who had turned 72 in 2022 had to take an RMD by April 1, 2023. The starting age for RMDs will move up to 75 in 2033.

The SECURE Act also changed the rules around inherited IRAs. Previously, the “stretch IRA” strategy allowed any beneficiary who inherited a traditional IRA to take withdrawals over their entire lifetimes — a significant tax benefit. But in 2019, the SECURE Act changed that by creating two primary “classes” of beneficiaries: eligible designated beneficiaries, and non-eligible designated beneficiaries. When it comes to inherited IRA withdrawals, these classes have different rules.

Who Will Not Be Affected by the New Rule?

The newly clarified RMD rules on inherited IRAs do not apply to heirs who qualify as “eligible designated beneficiaries.” These include:

•  Surviving spouses
• People with disabilities
•  Minor children
• People with chronic illnesses
•  Individuals not more than 10 years younger than the decedent

When eligible designated beneficiaries inherit a traditional IRA, they can still use the “stretch IRA” strategy, taking distributions over their lifetimes (with the exception of minor children, who revert to the “10-year rule” when they turn 21).

Who Will Be Affected by This Rule?

The new rule will impact non-eligible designated beneficiaries — effectively, everyone who doesn’t fit into the “eligible” categories. The 2019 SECURE Act effectively ended the stretch IRA for these beneficiaries by introducing the “10-year rule.” This rule requires that the entire balance of an inherited IRA be withdrawn within 10 years.

The RMD requirement hinges on whether the account holder had already started taking RMDs:

•  If the original IRA owner had begun taking RMDs before their death, non-eligible designated beneficiaries must fully deplete the funds in an inherited IRA by the end of the 10th year following the year of death of the IRA owner. They must make taxable RMDs, starting in 2025.    
• However, if the original IRA owner had not begun taking RMDs before their death, non-eligible designated beneficiaries are only subject to the 10-year rule, with no annual RMDs required.

In short: For non-eligible designated beneficiaries, RMDs will apply to inherited traditional IRAs and other qualified retirement plans (such as 401(k)s and 403(b)s), inherited on or after January 1, 2020, from someone who was making RMDs.

There are consequences for those who don’t take their RMDs as scheduled. The IRS levies a 25% penalty on the amount the account holder should have taken out. If the mistake is corrected within two years, the penalty can be cut to 10%. Because of the lack of clarity around the RMD requirements, the IRS won’t penalize beneficiaries who failed to take RMDs from IRA accounts inherited between 2020 and 2024. The RMD requirements for affected beneficiaries will begin in 2025.

It’s worth noting that in contrast to traditional IRAs, Roth IRAs, Roth 401k accounts, Roth 403b accounts, and Roth 457b accounts are tax advantageous to heirs. Beneficiaries must still withdraw the assets within 10 years, but they won’t have to make annual distributions. Plus, withdrawals are tax-free.

This can be especially beneficial for heirs in a high-income tax bracket.

Key Tax Planning Considerations

A word of caution: It pays to be strategic about your required distributions. If you take out only the minimum required amount each year, you might be forced to make a super-sized distribution at the end of the 10-year period—especially assuming the account continues to grow. This will trigger a large taxable event.

Speaking of taxes, you’ll also want to consider your tax bracket as you plan your distributions. When you’re earning more, avoid taking out large withdrawals—and vice versa. If your income declines, it might make sense to take out more sizeable amounts.

Even with this new clarity from the IRS, the matter of RMDs remains a complicated topic, with many factors to consider. The age of the original account holder, the date they passed away, and their relationship to the beneficiary all impact the rules for distributions from inherited IRAs.

An experienced financial advisor can help you make sense of these complex rules and navigate the decisions you’ll need to make for the best possible outcomes. Whatever your unique situation, the advisors at Wealth Enhancement are ready to help you craft your future. Schedule a meeting today to find out how we can help.