Based on the 10-Year RMD rule finalized by the IRS in late July, inherited retirement assets will be subject to different treatment depending on the recipient, starting in 2025.
On July 19, 2024, the IRS and Treasury Department released long-awaited Final Regulations for Inherited Retirement Account Required Minimum Distributions or “RMDs” (T.D. 10001). RMDs are mandated yearly withdrawals from IRAs, 401(k)s and other tax deferred retirement plans.
The final regulations clarify changes brought about by the SECURE Act, which took effect in 2020, and the SECURE 2.0 Act, which was signed into law at the end of 2022. The new rules start taking effect on January 1, 2025 and apply to retirement plan participants, IRA owners, and their beneficiaries.
Background
The genesis of the new regulations dates back to the 2019 enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. One of the many changes in that tax law was the elimination of so-called “stretch IRAs.” Previously, all beneficiaries of inherited IRAs could stretch RMDs over their entire life expectancies. Younger heirs in particular benefited by taking smaller distributions for decades, deferring taxes while the accounts grew. These heirs also could pass on the IRAs to later generations, deferring the taxes even longer.
The SECURE Act created limitations on which heirs can stretch IRAs. These limits are intended to force beneficiaries to take distributions and expedite the collection of taxes. Specifically, for IRA owners or defined contribution plan participants who died in 2020 or later, only “eligible designated beneficiaries” (EDB) are permitted to stretch out payments over their life expectancies.
- Eligible designated beneficiaries (EDB) – as defined by the IRS include the following: Surviving spouses, Children younger than “the age of majority,” Individuals with disabilities, Chronically ill individuals, and Individuals who are no more than 10 years younger than the account owner. The bottom-line is that eligible designated beneficiaries have other options for dealing with an inherited retirement account and may not be limited to the 10-year rule. (Note that self-certification of disability or chronic illness is not sufficient under the final regulations, which require documentation.)
- Designated beneficiaries (DB)—are all other heirs who are not an EDB (commonly, the adult children or grandchildren of a plan participant. ) Designated beneficiaries are required to take the entire balance of the account within 10 years of the death, regardless of whether the deceased died before, on or after the required beginning date (RBD) of his or her RMDs. This is known as the “10-year rule.”
Proposed regulations muddied the waters
In February 2022, the IRS issued proposed regulations addressing the 10-year rule — and they brought some bad news for many affected heirs. The proposed regulations provided that, if the deceased dies on or after the RBD, designated beneficiaries must take their taxable RMDs in years one through nine after death (based on their life expectancies), receiving the balance in the tenth year. A lump-sum distribution at the end of 10 years wouldn’t be allowed.
The IRS soon heard from confused taxpayers who had recently inherited IRAs or defined contribution plans and didn’t know when they were required to start taking RMDs. Designated beneficiaries could have been hit with a penalty based on the amounts that should have been distributed but weren’t. This penalty was 50% before 2023 but was lowered to 25% starting in 2023 (or 10% if a corrective distribution was made in a timely manner). The plans themselves could have been disqualified for failing to make RMDs.
As a result, the IRS issued a series of waivers on enforcement of the 10-year rule.
Final regulations settle the matter
With the release of the final regulations, the waivers will come to an end after 2024. The Final regulations distinguish between:
- a) instances in which the original participant began taking RMDs before they died and
- b) instances when they died before they started taking RMDs.
The final regulations also follow proposed regulations and continue to differentiate between eligible designated beneficiaries and designated beneficiaries.
Timing of RMDs: You may hear reference to the “at least as rapidly” rule a great deal while talking about inherited IRAs. The rule emphasizes the frequency of withdrawal, and not the amount of the withdrawal.
In simple terms, that means if the person who died was themselves taking RMDs due to their age at time death, designated beneficiaries must make annual withdrawals during the 10-year period. Under the life expectancy rules, what’s left in the account has to be distributed to the beneficiaries at the same rate or faster—you can’t take fewer distributions.
Conversely, the final regulations stipulate that, upon the original account owner’s death, and assuming said owner died before they reach their required beginning date to commence RMDs, designated beneficiaries and their advisors do have flexibility in how to withdraw funds. While the account still has to be fully liquidated under the same timeline, no annual distributions are required. That gives designated beneficiaries more opportunity for tax planning.
But, as already noted, if RMDs had already started, for designated beneficiaries they must continue based on the new 10-year time horizon.
Regardless of the specifics, all the money must be out of the account within a decade.
The rules are still complicated for a several reasons. One is that the age at which someone must take required minimum distributions has changed twice since the first Secure Act was signed into law in 2019 and the Secure 2.0 Act that followed in 2022 — from 70.5 years old to 72 and now 73 (it will be 75 in 2033).
What About Roth IRAs?
Roth accounts: Owners of Roth accounts are not subject to RMDs. That has always been the case for Roth IRAs. Until Secure 2.0, however, RMDs from designated Roth accounts including Roth 401(k), Roth 403(B) or Roth 457(b) were required, even though those withdrawals were not subject to income taxes. Starting in 2024, RMDs from these Roth designated accounts are no longer mandated.
As a result, the rules that apply to beneficiaries of Roth IRAs and DRAs for 2024 and after are the same as those that apply to beneficiaries who inherit traditional accounts from someone who died before they were supposed to start taking RMDs.
Whether the account was split between Roth and traditional investments, however, will also affect how distributions must be treated.
These rules will be covered separately in a future communication.
Other Points to Note
The IRS has allowed all designated beneficiaries to skip RMDs from inherited IRAs for 2020, 2021, 2022, 2023 and 2024 without facing any penalties.
The final regulations state that no RMDS will be required for this 4-year period. The 10-year window, however, will not be extended for designated-beneficiaries. Instead, designated beneficiaries will have to abide by the 10-year period beginning at the time of inheritance. Once again, however, designated beneficiaries will not have to take RMDs retroactively.
Additional Proposed Regulations
The IRS released another set of proposed regulations regarding other RMD-related changes made by SECURE 2.0, including the age when individuals born in 1959 must begin taking RMDs. Under the proposed regulations, the “applicable age” for them would be 73 years. They also include rules addressing: The purchase of an annuity with part of an employee’s defined contribution plan account, Distributions from designated Roth accounts, Corrective distributions, Spousal elections after a participant’s death, Divorce after the purchase of a qualifying longevity annuity contract, and Outright distributions to a trust beneficiary. The proposed regulations would take effect in 2025. Stay tuned.
Questions?
The final regulations are 162 pages long and cover other pertinent information about RMD rules for account owners and beneficiaries. This article only scratches the surface. As with most regulations, the IRS is anticipated to provide further clarifications when necessary.
IMPORTANT: The rules related to RMDs are complicated, especially due to changes to the SECURE Act and the SECURE 2.0 Act. If you’ve inherited an IRA or a defined contribution plan and are unsure of whether you should be taking RMDs, contact your Warady & Davis LLP advisor at (847) 267-9600 or [email protected]. We are happy to help you determine the best course of action for your tax situation.
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