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IRS Delivers Answer to Heirs on Inherited Retirement Accounts
After almost five years of uncertainty, on July 18, 2024, the Internal Revenue Service (“IRS”) finalized a ruling which clarifies that individuals who inherit retirement accounts must withdraw the funds within a 10-year period with minimum withdrawals to be made on a yearly basis. This new ten-year rule is applicable to 401(k)s, IRAs, and other pre-tax contribution plans inherited on or after January 1, 2020. It is important to note that these new rules do not apply to accounts inherited before 2020, or to Roth IRAs.
Historically, most beneficiaries could take smaller distributions throughout their lifetime based upon their own actuarial life expectancy (also known as a “stretch IRA”), thereby allowing the retirement accounts to have significantly more tax-deferred growth potential. However, in 2019, under the SECURE Act 2.0, individuals inheriting retirement accounts were required to take withdrawals within 10 years. The wording of the Act created uncertainty as to whether the designated beneficiaries of these retirement accounts would be forced to take a distribution from such account in each of the ten-years, or if they could wait until the end of the ten-year period to withdraw the entirety of the assets in the account. Understandably, this led to confusion among taxpayers and their advisors.
This recent ruling by the IRS makes the distribution standard definitive. Funds must be withdrawn each year, although how much the beneficiary must withdraw varies. These withdrawal rules generally apply to adult children, grandchildren, siblings, and friends and other non-relatives inheriting such accounts. The rules do not apply to spouses and minor children, sometimes referred to as “eligible designated beneficiaries” (“EDB”s), nor to persons who are not more than 10 years younger than the deceased, and disabled/chronically ill beneficiaries. The rules also do not apply if the person with the retirement account died before required distributions were initiated, which is currently anyone under the age of 73. The IRS ruling states that required distributions should commence on April 1 following the calendar year in which the retirement account holder would have attained age 73. However, if the person who died was required to take withdrawals, the person who inherits the account must take annual payouts starting the year after the death of the account holder.
Another area of clarification is what happens when a beneficiary fails to take the required minimum distributions (“RMD”). Effective 2023, Congress reduced the penalty for missed withdrawals from 50% of the amount that should have been withdrawn to half of that, 25%. However, due to the confusion in the Secure Act 2.0, many individuals did not take distributions over the last several years. Recognizing the lack of clear guidance on this point, the IRS has now confirmed that these missed withdrawals will not be penalized, for those who failed to take the RMD’s for the years 2021 through 2024. This relief does not require taxpayers to make up missed required minimum distributions nor does it permit the beneficiaries of such accounts to extend the 10-year deadline by which a full distribution is required to be made. For example, if the retirement account holder passed away in 2020, then in 2025, there would still be six years remaining in the 10-year period without regard to whether the designated beneficiary took distributions in 2021, 2022, 2023, or 2024. In 2030, the designated beneficiary must take a distribution of the remaining account balance.
The IRS ruling also clarified additional rules. For example, if the deceased owner of the IRA had already begun taking RMDs, then the beneficiary’s annual distribution would be based on their own life expectancy, with all of the money needing to be withdrawn by the end of the tenth year. Moreover, if the beneficiary fails to take the RMD as required, he or she will face a 25% penalty on any deficiency. Even though the named beneficiaries to these retirement accounts can withdraw varied amounts over the ten-year period, it is important to remember that the withdrawals are treated as taxable income, and beneficiaries will want to carefully plan out how much they want to withdraw each year.[1]
The laws governing the trillions of dollars held in retirement accounts is an ever-changing landscape likely due to continued efforts by Congress to raise revenue and deter the wealthy from shielding their assets generationally. Individuals should remain informed and up to date on changes in order to better plan for their retirement. As with many aspects of estate and financial planning, is prudent to seek advice from professionals who can assist in understanding the implications and nuances of applicable laws and how they may affect your individual future planning goals.
[1] EDB’s are still allowed to take distributions over their lifetimes with surviving spouses enjoying the most flexibility. It has long been the rule with a spousal inherited IRA that the surviving spouse can treat the inherited IRA as their own, or take distributions based on their life expectancy.
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Trusts and Estates Alert is produced by Tannenbaum Helpern Syracuse & Hirschtritt LLP’s Trusts and Estates practice and provides insights on recent legislation and other legal developments impacting estate planning and administration and related disputes. To subscribe to the newsletter, email marketing@thsh.com.
07.30.2024 | PUBLICATION: Trusts and Estates Alert |