The IRS has for the third consecutive year offered relief to taxpayers covered by the “10-year rule” for required minimum distributions (RMDs) from inherited IRAs or other defined contribution plans. Let’s look at how this may affect your retirement and estate plans.
Rules for RMDs
Once you reach a specified age — known as the required beginning date (RBD) — you must begin taking RMDs from your IRA on an annual basis. Comparable rules apply to qualified plans such as 401(k) accounts.
Previously, the RBD was generally April 1 of the year following the year you reach age 70½. The Setting Every Community Up for Retirement Enhancement (SECURE) Act extended the age to 72, beginning in 2020. SECURE 2.0, a follow-up to the initial SECURE Act, increased the age to 73, beginning in 2023.
The amount of your RMDs is based on the account balances on December 31 of the prior year and IRS-approved life expectancy tables. Absent special waivers from the IRS, you must take RMDs in each succeeding year. RMDs are taxed at ordinary income rates currently topping out at 37%.
Rules for inherited IRAs
Before the SECURE Act, all beneficiaries of inherited IRAs were allowed to stretch the RMDs on the accounts over their entire life expectancies. For younger heirs, this meant they could take smaller distributions for decades, deferring taxes while the accounts grew. They also had the option to pass the IRAs on to later generations, which deferred the taxes even longer.
Note that the SECURE Act rules don’t apply to stretch IRAs created before 2020. These IRAs are “grandfathered” by the law and can continue to operate under the prior rules.
To avoid this extended tax deferral, the SECURE Act imposed limitations on which heirs can stretch IRAs. Specifically, for IRA owners or defined contribution plan participants who died in 2020 or later, only “eligible designated beneficiaries” may stretch payments over their life expectancies. The following heirs are eligible designated beneficiaries:
- Surviving spouses,
- Children younger than the “age of majority,”
- Individuals with disabilities,
- Chronically ill individuals, and
- Individuals who are no more than 10 years younger than the account owner.
All other heirs (designated beneficiaries) must take the entire balance of the account within 10 years of the death, regardless of whether the deceased died before, on or after the RBD for RMDs.
Proposed regs added to confusion
The IRS issued proposed regulations in February 2022 that came with an unwelcome surprise for many affected heirs. Under the proposed regs, beneficiaries of IRAs where the account owner had attained their RBD must take their taxable RMDs in years one through nine after death (based on their life expectancies). They must then receive the balance in the 10th year. In other words, they aren’t permitted to wait until the end of 10 years to take a lump-sum distribution. This annual RMD requirement gives beneficiaries much less tax planning flexibility and could push them into higher tax brackets during those years.
This caught many beneficiaries, as well as their professional tax advisors, by surprise. It also led to greater uncertainty in estate planning. In particular, it wasn’t clear if RMDs must be spread over the applicable 10-year period.
In response, only six months after the proposed regs were published, the IRS waived enforcement against taxpayers subject to the 10-year rule who:
- Missed 2021 and 2022 RMDs if the plan participant died in 2020 on or after the RBD, or
- Missed 2022 RMDs if the participant died in 2021 on or after the RBD.
The waiver guidance indicated that the IRS would issue final regs that would apply no earlier than 2023. But the IRS later extended the waiver relief to excuse 2023 missed RMDs if the participant died in 2020, 2021 or 2022 on or after the RBD.
In Notice 2024-35, the IRS has again extended the relief, this time for RMDs in 2024 from an IRA or defined contribution plan when the deceased passed away during the years 2020 through 2023 on or after the RBD. If certain requirements are met, beneficiaries won’t be assessed a penalty on missed RMDs, and plans won’t be disqualified based solely on such missed RMDs.
Final regs on the horizon
As of the writing of this article, the IRS has yet to issue final regs for the rule that will apply for the purposes of determining RMDs from inherited IRAs or qualified plans in 2025. In the meantime, consult with your estate planning advisor for the latest information and to learn more on how the proposed regs may affect your retirement and estate plans.
SIDEBAR: What’s the penalty?
It’s important to note that you must continue to take required minimum distributions (RMDs) from your IRA and/or qualified plans if you’ve reached your required beginning date. Don’t make the mistake of ignoring or forgetting about this responsibility.
Failing to take timely RMDs from inherited IRAs or other defined contribution plans can result in unwanted tax consequences. The penalty, however, isn’t as severe as it was before the latest tax law changes.
In the not-so-distant past, the penalty was equal to a staggering 50% of the amount due (or any shortfall, if lesser). But the SECURE 2.0 law cut the penalty in half, to 25%. Furthermore, the penalty is reduced to 10% if the error is corrected in a timely fashion.
Of course, you still must pay the regular tax on RMDs. Don’t add insult to injury by incurring a penalty.
