The new 10-year distribution rule for inherited retirement accounts has opened the door to some potentially costly mistakes for beneficiaries who misinterpret the rule.
Per the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, many non-spouse beneficiaries who inherit an IRA or 401(k) must now liquidate their account assets in full within 10 years of the original owner’s death, paying ordinary income tax on distributions from tax-deferred accounts.1
The rule effectively eliminated the so-called stretch IRA, which previously permitted non-spouse beneficiaries to stretch out distributions from an inherited IRA over their own projected life expectancy, allowing them to benefit from tax-deferred growth for longer. (Learn more: Stretch IRA? Four possible alternatives)
“This was actually a pretty large change for non-spouse beneficiaries,” said Reed Willett, a financial professional with Coastal Wealth in Ft. Lauderdale, Florida. “We still have this conversation with clients [about the new distribution rules] on a regular basis, even more than two years later. There is still confusion as to whether a required minimum distribution [RMD] applies.”
Beneficiaries who seek to maximize the size of their inheritance must educate themselves on who is required to liquidate their account, which retirement accounts are included, and how their RMDs may affect their tax bill. A financial professional can offer critical guidance and help you avoid the most common mistakes.
Draining their IRA prematurely
For example, some beneficiaries of an inherited retirement account adhere to the 10-year payout rule when they are, in fact, exempt. In doing so, they deny those dollars a chance to continue delivering tax-deferred growth over their own life expectancy, a potentially significant opportunity cost.
A $200,000 inherited IRA, in which distributions are held to the required minimum, could potentially pay out more than $3 million in income before taxes and fees over 50 years. That example assumes an early age of inheritance and an 8 percent annualized return.2
Before you liquidate your inherited account on a 10-year schedule, be sure you do not fall into an exempt category. Those include the following:
- Surviving spouses are not required to take a distribution or withdraw from their deceased spouse’s IRA on a 10-year schedule. Spouses may either treat it as their own by designating themselves as the account owner, roll the money into their own IRA, or treat themselves as the beneficiary rather than treating the IRA as his or her own. Each have their own RMD rules.3
- The 10-year payout rule only applies to non-spouse beneficiaries if the original owner of the retirement account passed away after Jan. 1, 2020. Non-spouse beneficiaries who inherited an IRA from an individual who died prior to that date may continue to stretch their distributions out over their projected lifetime using the IRS Single Life Expectancy tables.
- Generally, non-spouse beneficiaries who are 10 years younger or less than the original plan participant (such as a sibling) may also still take RMDs based on their own life expectancy.
- Minor children who inherit a parent’s IRA are also exempt from the 10-year rule, at least until they reach the age of majority, which is typically age 18. Before turning 18, the child would still have to take annual RMDs based on their own life expectancy. But at the age of majority, they would switch to the 10-year rule.
- If the original account owner left their IRA to an estate, trust, or charity rather than naming a designated beneficiary, the 10-year rule does not apply.
- Beneficiaries who are chronically ill or those with a qualified disability may continue to stretch their inherited IRA distributions.
Penalties for noncompliance
Beneficiaries who are required to withdraw their accounts in full must be sure they do so within the required time frame for all applicable accounts, lest they be penalized for noncompliance.
Non-spouse beneficiaries who inherit an IRA or 401(k) and do not meet one of the exceptions must fully withdraw all account assets by December 31 of the year containing the 10th anniversary of the original owner’s death. Failure to do so would result in a hefty 50 percent penalty on the amount of the RMD not withdrawn.
The 10-year payout rule includes inherited Roth IRAs.
“Most people don’t realize that this act applies to both traditional and Roth IRAs,” said Scott Warshaw, a financial professional with Broad Street Financial in Bala Cynwyd, Pennsylvania, noting that the confusion is understandable because the original owner of a Roth IRA account is not required to take minimum distributions during their lifetime.
Non-spouse beneficiaries who inherit a Roth IRA are not required to pay taxes on their distributions, because the Roth IRA was originally funded with after-tax contributions, but they are beholden to the 10-year payout rule. (Note that non-spouse beneficiaries younger than age 59½ would not be assessed the traditional 10 percent penalty for an early IRA withdrawal because the RMDs on inherited IRAs are mandatory.)
That said, spouses and other eligible designated beneficiaries should be aware of the additional flexibility they have in electing a distribution option. (Related: Social Security options for the widowed)
“The spousal situation is unique where sometimes a younger spouse under the age of 59½ may need the money sooner and can actually elect to have the 10-year rule apply to them in order to avoid an early withdrawal penalty — but the other side of that coin is that they now have to distribute the account in full within 10 years,” said Willett, noting that they cannot initiate the 10-year payout rule and then switch to a different distribution schedule later on.
It is also important to note that the timeline to distribute assets from an IRA you inherit through a deceased individual’s estate is different (shorter) than it would be if you were specifically named as a designated beneficiary. In that case, you must liquidate the IRA by December 31 of the year containing thefifth anniversary of the original account owner’s death.
It’s up to you to know the rules.
“The IRS places the responsibility on the account owner to know the rules, and this is not exactly elementary-level information,” Willett said, urging beneficiaries to educate themselves carefully and consult a professional for guidance where appropriate.
Paying avoidable taxes
Other beneficiaries of inherited IRAs make the costly mistake of failing to consider the tax implications of their RMDs.
Indeed, most who inherit an IRA do so during their 50s and early 60s when their parents pass away, which are likely their peak earnings years.
By choosing to take a lump-sum distribution of the entire account balance from a traditional IRA or 401(k) in, say, year 10, they could expose themselves to a much higher tax bill. In many cases, it may be wise to take even distributions over 10 years to prevent a spike in taxable income, said Willet.
“If a massive distribution is taken from a tax-deferred inherited retirement account in a single year and it pushes you into a higher tax bracket, that could be detrimental,” he said.
Any amount you distribute from a tax-deferred traditional IRA or 401(k) is subject to ordinary income taxes, but, again, you’ll owe no income tax on withdrawals from an inherited Roth IRA because the account was funded by the original account owner with after-tax contributions.
A careful withdrawal strategy is key.
“There’s a whole element of tax planning that’s been added to this, especially for sizable inherited accounts,” said Warshaw. “This is actually the piece that will probably get fumbled the most by people who don’t realize the tax implications.”
A tax professional can help beneficiaries ensure that they pay what they owe and nothing more.
For example, those who inherit a large traditional IRA that was subject to the federal estate tax may be able to offset a portion of their income tax bill with a valuable write-off. How? The estate of the original IRA owner was required to pay a federal estate tax on the IRA, which beneficiaries get to claim as an income tax deduction. In such situations, it’s usually wise to consult a tax professional.
The estate tax exemption limit is $12.06 million ($24.12 million for married couples) in 2022.
The 10-year payout rule on inherited IRAs for non-spouse beneficiaries is fertile ground for misinterpretation, which can have costly consequences.
To avoid unnecessary penalties and minimize your tax bill, it is important to educate yourself on which beneficiaries must liquidate their inherited accounts and when.
Many choose to consult a financial professional for guidance.
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1 Internal Revenue Service, “Publication 590-B (2021), Distributions from Individual Retirement Arrangements (IRAs),” May 2, 2022.
2 Putnam Investments, “Stretch an IRA over generations,” May 2019.
3 Internal Revenue Service, “Retirement Topics – Beneficiary,” Sept. 27, 2021.