When Congress passed the SECURE Act four years ago, the rules for most beneficiaries of inherited IRAs underwent a major overhaul. Prior to the SECURE Act, most IRA beneficiaries were able to spread their required minimum distributions (RMDs) over their life expectancy. As part of the SECURE Act, Congress introduced the term eligible designated beneficiary, a category encompassing spouses, disabled or chronically ill individuals, and individuals who are not more than 10 years younger than the owner of the account. The SECURE Act specified that only eligible designated beneficiaries would retain the ability to stretch their RMDs over their life expectancy and that non-eligible designated beneficiaries would be subject to a new 10-Year distribution rule[i]. This rule requires beneficiaries to fully distribute the inherited balance by the end of the 10th year following the owner’s death.
When the 10-Year Rule went into effect in 2020, it was widely interpreted as meaning that non-eligible designated beneficiaries would no longer be required to take annual distributions, so long as the account was fully depleted by the end of the 10th year. For beneficiaries who were expecting to have a material reduction in their taxable income soon, this presented an opportunity to delay distributions in hopes of withdrawing a larger portion of the balance in years where the distributions would fall into a lower tax bracket.
Many who inherited IRAs after 2020 proceeded to operate on the assumptions previously mentioned and chose to forego distributions in the subsequent years. However, in early 2022 the IRS released proposed regulations indicating that beneficiaries would only have the option of foregoing annual distributions if the original account owner passed away prior to their RMD required beginning date. Understandably, this created a great deal of confusion and left beneficiaries to wonder whether they would be penalized for missed RMDs. Fortunately, in October of 2022 the IRS issued a notice indicating that this regulation would be enforced no sooner than 2023, meaning that beneficiaries who had operated under the above assumptions would not be subject to penalties. In July of 2023, the IRS released yet another notice extending the beginning date for this regulation to no earlier than 2024.
These evolving regulations have left many beneficiaries wondering how to proceed in 2023 and beyond. The most important step at this stage is for beneficiaries to take a step back and determine what category they fall into. For example:
- Were they designated as a beneficiary on the account?
- Do they meet the criteria of an eligible designated beneficiary?
- If they do not meet the eligible designated beneficiary criteria, had the original owner already reached their required beginning date for RMDs before their passing?
Working through these questions with your advisor, you should be able to reach an understanding of how these new regulations will apply to your situation.
With this understanding in mind, it will then be possible to look objectively at the current year and determine whether a distribution is appropriate. While the new regulation may not yet be in effect for 2023, there are still many beneficiaries for whom it will still be prudent to take a distribution.
To illustrate, suppose that a beneficiary sits near the top of the 24% tax bracket and expects no material changes in their income for the coming years. If they wait to distribute funds until the later years, they run the risk of a larger portion of the account balance getting pushed into the 32% tax bracket when distributions are taken. One should also consider that the current tax brackets are set to sunset back to their pre-tax cuts and jobs act levels after 2025, at which point the 24% bracket will return to 28% and the 32% bracket will return to 33%. By contrast, beneficiaries who are on the cusp of retirement, may be best served by forgoing a distribution in 2023 and taking a larger portion of their withdrawals in a lower bracket.
The appropriate decision will look different depending on each person’s circumstances and life plans. Partnering with your advisor is the best way to ensure that you make the decision that is best for you.
Disclosure: Information contained herein is subject to legislative changes and is not intended to be legal or tax advice. Consult a qualified tax advisor regarding specific circumstances. This material is furnished “as is” without warranty of any kind. Its accuracy and completeness are not guaranteed and all warranties expressed or implied are hereby excluded. To ensure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication (including attachments) is not intended or written to be used and cannot be used for (1) avoiding penalties imposed under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein unless the communication contains explicit language that it is a tax opinion in compliance with IRS requirements.
[i] Note that the 10-Year rule does not apply to non-designated beneficiaries. Under the SECURE Act, any non-designated beneficiary is still subject to either distributions based on the life expectancy of the owner or the 5-Year rule, depending on whether the owner had reached their required beginning date for RMDs.