Individuals who recently came into possession of retirement accounts now have clarity from the Internal Revenue Service regarding the process for withdrawing funds. Several tactics can assist you in minimizing what goes to the IRS unnecessarily.
The bewildering rules surrounding inherited Individual Retirement Accounts (IRAs) and similar savings plans are akin to a Rube Goldberg machine. However, the Internal Revenue Service (IRS) has recently clarified certain elements related to required minimum distributions (RMDs). Handle this correctly, and you might be able to evade a substantial tax liability.
On July 18, the IRS released guidelines stating that most non-spousal beneficiaries are required to withdraw funds annually from their inherited IRAs or 401(k) plans, assuming the initial account holder had already started making Required Minimum Distributions (RMDs). According to IRA specialist Ed Slott, "Think of RMDs as a faucet; once it’s turned on, it cannot be shut off."
Since the enactment of the Secure Act in 2019, which removed the "stretch IRA" provision for most non-spousal beneficiaries inheriting an account as of January 1, 2020, heirs have remained uncertain. The previous regulation allowed grown-up offspring and other inheritors to withdraw funds gradually throughout their lifetime, thus enabling greater accumulation within the inherited account. However, policymakers believed this arrangement offered substantial tax advantages and decided to abolish it in order to hasten income generation from these accounts.
Instead of stretching withdrawals over time, the legislation mandates that most non-spousal beneficiaries must empty the inherited account within ten years following the decedent's passing. However, it did not outline how funds should be withdrawn during this period. Initially, many tax professionals believed that heirs had the option to withdraw all the money at the very end of the decade-long timeframe.
At the beginning of 2022, the Internal Revenue Service suggested more stringent regulations for individuals who inherited an Individual Retirement Account (IRA) from someone who was already required to withdraw Required Minimum Distributions (RMDs). In such cases, these beneficiaries were expected to adhere to their own yearly withdrawal schedules. However, due to significant confusion and debate surrounding this proposal, the IRS decided to waive the RMD obligation for this year.
The IRS' latest guidelines state that most non-spousal beneficiaries must begin their Required Minimum Distributions (RMDs) by 2025, assuming they haven't done so already. The consequence for failing to take these distributions includes a penalty of 25% of the sum that was supposed to be withdrawn. Below is essential information regarding this requirement.
What happens if I inherited an IRA prior to 2020?
The new regulations do not apply to you. You are exempt from them due to being part of the previous stretch IRA rule framework that was effective prior to the law being enacted.
What happens if I received an IRA from my deceased spouse?
None of these modifications affect spouses, who have much greater leeway when they inherit IRAs. They have the option to transfer their deceased spouse’s IRA into their own retirement plan or maintain it as an inherited account. In either case, they can extend withdrawals according to their life expectancy rather than adhering to the 10-year rule.
Are there additional beneficiaries capable of extending required minimum distributions throughout their own life spans?
Certainly. Surviving spouses fall under a specific classification known as "eligible designated beneficiaries." This category also encompasses individuals who are not older than ten years compared to the initial IRA holder, people with chronic illnesses or disabilities, and minors—not grandkids—who belong to the original account owner.
The concluding regulation specifies that minor children may encompass stepchildren and foster children. Nevertheless, when these beneficiaries turn 21, they are considered adults, initiating the 10-year period.
What happens if I inherit a traditional IRA after 2019 from an individual who was already making required minimum distributions?
You have to start making Required Minimum Distributions (RMDs) by 2025 unless you've begun doing so earlier. There's no need to pay back missed distributions from previous years where this rule wasn't enforced. Nevertheless, those skipped years still play into your calculations moving forward. For figuring out future RMD amounts, refer to IRS Publication 590-B to get the applicable life expectancy factor corresponding to the year following the demise of the account holder, as mentioned by Slott.
Suppose you received an IRA inheritance in 2020 when you were 50 years old. By 2025, you would calculate the account balance as of the end of this year by dividing it by 31.3, which represents your remaining life expectancy since you will be 51 in 2021, the year following the receipt of the inheritance.
For years one through nine, the life-expectancy factor approach is used. In year ten, however, you have to withdraw the leftover amount.
What should my actual withdrawal amount be?
Keep an eye on potential tax implications when taking just the mandatory minimum until year nine; this might result in a larger sum needing withdrawal in the last year. Each withdrawn amount contributes to your yearly taxable income. Spreading out these distributions evenly throughout the designated period can reduce the chance of facing significant taxes during the tenth year. Always be aware of your current tax bracket and try not to pull funds that could push you into a higher one unnecessarily.
An additional aspect to keep in mind is that the present tax rates are set to lapse at the conclusion of 2025. Without intervention from Congress, the lower brackets established under theTax Cuts and Jobs Act of 2017will return to their previous amounts. Opting for increased withdrawals currently might help reduce your overall taxes.
An exemption exists if your intention is to retire within the distribution phase, as pointed out by Evan Potash, an executive wealth management advisor at TIAA from Newtown, Pennsylvania. Should you anticipate moving into a lower tax bracket shortly, it might be prudent to withdraw just the mandatory amount until this change occurs.
What happens if I received an IRA inheritance after 2019 from someone who wasn’t yet required to take Required Minimum Distributions (RMDs)?
You don’t need to take annual RMDs, but you still have to empty the account by the end of the tenth year following the original account holder’s death. It might still make sense to withdraw some each year, to stagger your tax liability and take advantage of today’s lower rates.
What would happen if I received a Roth account as an inheritance?
Roth accounts do not have required minimum distribution rules, yet they must be fully distributed within ten years following the demise of the initial account holder. Beneficiaries will not incur income tax on these withdrawals, so if you find yourself with surplus funds, it might be wise to let them grow untapped until the tenth year.
Send an email to Elizabeth O'Brien at elizabeth.obrien@barrons.com
