IRA Beneficiary Rules Still Need Clarification

The SECURE Act of 2019 changed the rules for beneficiaries inheriting tax-deferred retirement savings to require, in some cases, that assets be distributed (and taxed) more quickly following the IRA owner’s death than was required under the old rules. These new rules apply to beneficiaries who inherit IRA assets on or after January 1, 2020, while the old rules continue to apply for those who became beneficiaries before 2020. This was already a complex area of law. Now, with two sets of applicable rules, it’s even more challenging for beneficiaries to understand their options and the timing requirements. Making matters worse is the fact that some details on how to apply the new law are not yet clear. Beneficiaries should seek tax or financial planning assistance to make sure they fully understand the distribution options available to them and the tax consequences of those options. The following is a summary of the current interpretation of the rules.

The SECURE Act Changes in a Nutshell

The tax laws generally require beneficiaries to distribute inherited IRA assets within a certain time frame – that hasn’t changed. What has changed are the options beneficiaries may choose from to distribute assets from the IRA. Under the rules prior to the SECURE Act, the options for structuring payments from the IRA depended on the IRA owner’s age at death, the type of IRA, and the type of beneficiary. One of those options was to take a minimum payment each year, calculated based on either the beneficiary’s or the IRA owner’s remaining life expectancy. This option allowed beneficiaries to spread out the tax liability of their inheritance, potentially over many years, and to let the IRA investment continue growing tax-deferred for as long as possible. This option was often referred to as the “stretch IRA” strategy. The SECURE Act eliminated the stretch IRA option for all but a few types of beneficiaries.

Most Beneficiaries Limited to One Option

A human, designated beneficiary inheriting IRA assets in 2020 or beyond must now deplete an inherited IRA by the end of the 10th year following the year of the IRA owner’s death. For example, an IRA owner’s death in 2021 would require the beneficiary to distribute all inherited IRA assets by December 31, 2031. The distributions can be in any amount, in any year within this 10-year period. This includes the option to wait until the end of the 10th year to take a total distribution.

Although the stretch IRA option was taken away, these beneficiaries are allowed 10 years (rather than five years, which was the other option under the old rules) to deplete the IRA.

Certain Beneficiaries Have More Options

A sub-set of designated beneficiaries under the new rules, called Eligible Designated Beneficiaries (EDBs), retains the option to take annual life expectancy payments and stretch an inherited IRA. Only certain types of beneficiaries fall in this category:
• Surviving spouse of the IRA owner
• Minor child of the IRA owner (who becomes subject to the 10-year rule upon reaching the age of majority)
• Disabled or chronically ill individual
• Beneficiary who is not more than 10 years younger than the IRA owner

Spouse beneficiaries also retain the right to treat a decedent’s IRA assets as their own, generally through a transfer or rollover to their own IRA.

More Guidance Needed

Many of the details surrounding these new rules need clarification. The Treasury/IRS has indicated it will issue regulatory guidance on the beneficiary rules, possibly yet in 2021.

As we await that guidance, the industry was hopeful that the IRS’s plain language explanation of the IRA rules in Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), would provide some insight into how the new rules are to be applied. Unfortunately, the first release of the publication in 2021 contained some mistakes, confusing matters further. For example, the publication implied that beneficiaries subject to the 10-year rule would have to take a minimum payment from the inherited IRA each year of the 10 years. This was not how the old five-year rule was applied. A subsequent version of the publication confirmed that annual payments are not required under the 10-year rule.

One of the main outstanding questions plaguing the IRA industry after the latest version of Publication 590-B was released is whether EDBs can use the 10-year rule if the IRA owner dies after reaching his or her required beginning date (which is April 1 following the year the IRA owner turned 72). The IRS’s publication indicates that the 10-year rule is not an option under these circumstances.

This may not seem like a significant issue because beneficiaries can always take out more than the minimum required amount in any year, even if they are locked into the life expectancy payment option. But some beneficiaries may not want to take annual payments. For example, some may prefer to take a lump sum at the end of 10 years so they don’t have to liquidate an alternative asset to take minimum annual payments, or they may want to let an inherited Roth IRA investment continue to grow tax-free until the end of the 10th year.

If it turns out that the 10-year option is not available to these beneficiaries and they missed taking a required annual payment, they will be subject to a 50% penalty on the amount that should have been taken but wasn’t. If a spouse beneficiary misses a required payment, the spouse will be treated as assuming the beneficiary IRA as his or her own IRA, which may not be the spouse’s financial planning objective. When regulatory guidance is released, the IRS may offer transition relief for these beneficiaries for the first missed payment, but some industry experts are suggesting that EDBs who inherited in 2020 may want to consider taking a minimum distribution by the end of 2021 just in case.

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