IRS Proposed New Rules for Inherited IRAs Under the SECURE Act

The rules for inherited IRAs were upended when the Setting Every Commu- nity Up for Retirement Enhancement (SECURE) Act was enacted in 2019. They were upended yet again in late February 2022 when the IRS released proposed regula- tions under the SECURE Act.

The SECURE Act ended Stretch IRAs for most taxpayers who inherit IRAs after 2019, but not for all of them. A Stretch IRA is a strategy, not a special type of IRA. The Stretch IRA is when a beneficiary takes only the required minimum distributions (RMDs) from the inherited IRA each year. The RMDs often are fairly small, since usually they’re based on the life expectancy of the beneficiary.

The RMDs might be less than or sim- ilar to the annual investment gains. That allows the IRA to maintain a healthy balance for years before the beneficiary decides to begin spending it. Under the SECURE Act, most beneficiaries aren’t allowed to use the Stretch IRA. The inherited IRA must be fully distributed within 10 years.

The 10-year rule really can be close to an 11-year rule, because you don’t start counting the 10 years until the year after the IRA owner passed away. There are exceptions to the 10-year rule for certain beneficiaries who are called eligible designated beneficiaries (EDBs). The EDBs are a surviving spouse who is the sole primary bene- ficiary of the IRA; a minor child (but not a grandchild) of the IRA owner; a disabled beneficiary; a chronically ill beneficiary; or a beneficiary who is not more than 10 years younger than the deceased IRA owner. An EDB generally can use the pre-SECURE Act rules, allowing a Stretch IRA, at least to a point. A surviving spouse has special status. He or she can take full benefit of the old rules or choose to opt-in to the new rules. In a future issue, I’ll discuss in detail the strategies available to a surviving spouse.

The proposed regulations say that a minor child is one under age 21, regardless of the age of majority es- tablished by the beneficiary’s state of residence. The exception to the 10-year rule for a minor child applies only until the child reaches the age of majority.

Then, the 10-year rule kicks in and the IRA must be distributed within the follow- ing 10 years. For example, if an 11-year-old inherits an IRA, the child takes annual RMDs under the pre-SECURE Act rules until the child turns 21. Then the 10-year rule under the SECURE Act kicks in. The IRA must be fully distrib- uted by age 31.

The proposed regulations flesh out the definitions of disabled or chron- ically ill beneficiaries, which I won’t go into here. For a beneficiary who is not more than 10 years younger than the original IRA owner, the proposed regulations establish a strange rule that requires the beneficiary to track two life expectancies well into his or her 90s.

The rule is too complicated to explain here but will be in the revised edition of my report, Bob Carlson’s Guide to Inheriting IRAs, which will be available through the Retirement Watch website soon. The proposed regulations say that someone who’s an EDB can elect out of that status and choose to use the 10-year rule under the SECURE Act. But the IRA custodian doesn’t have to allow that election.

Perhaps the most significant part of the proposed regulations, and another unnecessary complication, applies to beneficiaries who are subject to the 10-year rule. Most tax advisors read the SECURE Act to say that no distributions would be required during the 10-year period, but the IRA had to be fully distributed by the end of the 10 years.

The pro- posed regulations say otherwise. Instead, whether the beneficiary might have to take annual RMDs during the 10 years depends on whether the deceased IRA owner had reached his or her required be- ginning date (RBD) for RMDs before passing away. If the IRA owner had not reached the RBD, then no distributions are required during the 10 years. The beneficiary can distribute the IRA in any pattern he or she wants, as long as it is fully distributed by the end of the 10 years. But if the IRA owner had reached the RBD, the beneficiary must take annual RMDs under the pre-SECURE Act rules during the first nine years.

In addition, the IRA must be fully distrib- uted by the end of the 10th year. A traditional IRA owner must begin RMDs by April 1 of the year after he or she turns age 72. So, the RBD is April 1 of the year after the owner turned 72. That means if someone turned 72 but passed away before April 1 of the fol- lowing year, the person hadn’t reached the RBD yet and RMDs won’t have to be taken by the beneficiary during the 10-year period.

That’s true even if the owner took an RMD during the calen- dar year during which he or she turned 72, which is allowed. But if the owner passed away any time after April 1 of the year after he or she turned 72, the beneficiary must take the annual RMDs and comply with the 10-year rule, even if the owner had failed to take any RMDs. RMDs aren’t required by original owners of Roth IRAs. That means there’s no RBD for a Roth IRA, so a beneficiary inheriting a Roth IRA doesn’t have to take RMDs during the 10 years, regardless of how old the Roth IRA owner was at the time of his or her death.

When a Roth IRA is inherited, the best strategy often is to leave the money in the Roth IRA until near the 10-year deadline, so the tax-free compounding of the Roth IRA is maximized. For inherited traditional IRAs, it’s more difficult to determine a strategy. One strategy is to wait to fully distribute the IRA near the end of the 10 years to maximize the tax-deferred compounding. But that could result in a few large sum distributions that push the beneficiary into a higher tax bracket and reduce the after-tax value of the inheritance. Most beneficiaries should plan the distributions from year to year based on their tax brackets and fluctuations in their other income and deductions. When other income is lower or deduc- tions are higher, distribute more than required. That might avert higher taxes on distributions in future years when the beneficiary might be in a higher tax bracket.

A beneficiary also should pay at- tention to the potential for higher tax rates in the future. It might be best to reduce the IRA balance ahead of either tax rate increases or when the benefi- ciary’s other income might push him or her into a higher tax bracket. Keep in mind that the lower rates of the Tax Cuts and Jobs Act are scheduled to expire after 2025. There’s no strategy that works best for all IRA beneficiaries.

A beneficiary needs to examine his or her cash needs and tax situation each year. While the distribution rules for suc- cessor beneficiaries weren’t clear before the SECURE Act, the Act specifically addressed successor beneficiaries of EDBs. When the initial beneficiary of an IRA or 401(k) qualified as an EDB, that status doesn’t pass on to any successor beneficiary. The 10-year rule applies to all successor beneficiaries of EDBs. The successor beneficiary must fully distribute the IRA within 10 years after inheriting it.

When the initial beneficiary was not an EDB and was taking distributions under the 10-year rule, the succes- sor beneficiary inherits that 10-year period. The successor beneficiary can’t start a new 10-year period. In addition, the proposed regula- tions state that when the initial bene- ficiary was taking annual RMDs, the successor beneficiary must continue those RMDs under the same schedule and still fully distribute the IRA by the end of the initial 10-year period. This means a successor beneficiary must learn if the initial beneficiary was taking or was required to take RMDs during the 10-year period.

In other words, the successor beneficiary must know if the original IRA owner died on or before his or her RBD. I continue to comb through the proposed regulations (they’re more than 275 pages) and will let you know as I find more important rules. For more details about inheriting IRAs, look for the revised edition of my report, Bob Carlson’s Guide to Inheriting IRAs, which will be available through the Retirement Watch website soon.