Navigating the IRS’s Finalized Regulations for Inherited IRAs

On July 18, 2024, the IRS released its long-anticipated finalized regulations concerning inherited IRAs Federal Register: Required Minimum Distributions. These regulations provide much needed clarity following the extensive changes introduced by the SECURE Act of 2019, which altered the landscape for individuals inheriting IRAs. While the final regulations largely align with the proposed rules issued in 2022, they also address some of the lingering uncertainties that emerged following the SECURE Act’s implementation, such as the application of the 10-year rule for most non-spouse beneficiaries. Below, we have outlined some key points of these regulations and what they could mean for you.

The SECURE Act introduced two primary classes of beneficiaries: eligible designated beneficiaries (EDBs) and non-eligible designated beneficiaries (NEDBs). Understanding which category you fall into is crucial as it determines how you must handle an inherited IRA.

Eligible Designated Beneficiaries:

• Surviving Spouses
• Minor Children of the Deceased (until they reach majority)
• Disabled Individuals
• Chronically Ill Individuals
• Individuals Not More than 10 Years Younger than the Decedent

EDBs can choose between two primary methods for distributions:

1. Stretch Method: If the original account owner was under required minimum distribution (RMD) age, passing away before their required beginning date (RBD), beneficiaries can take distributions based on their own life expectancy. If the original account holder had reached RMD age, distributions can be based on either the beneficiary’s life expectancy or the remaining life expectancy of the original account holder, whichever is longer. This option can be beneficial as it can minimize the tax impact by spreading out distributions over many years.
2. 10-Year Rule: Requires the entire balance to be distributed by the end of the 10-year period following the decedent’s death.

The IRS’s final regulations clarify that a plan can establish different rules for different categories of EDBs. For example, a plan might allow a surviving spouse to choose between the Stretch or 10-Year Rule while requiring all other EDBs to adhere to the 10-Year Rule.

Example: Ben passed away at age 45 in 2024 and his son Alex, age 10 is the beneficiary of his Traditional IRA. Alex can initially stretch distributions over his life expectancy until he reaches the age of majority. Once he turns 21 in 2035, he must follow the 10-year rule, which requires him to take annual RMDs and distribute the remaining balance by December 31, 2045. Although Ben passed away before his RBD for RMDs, Alex must continue taking annual RMDs during the 10-year period because they had already started.

Non-Eligible Designated Beneficiaries

NEDBs, which include most non-spouse beneficiaries, do not have the same flexibility as EDBs. The SECURE Act imposed a 10-Year Rule on these beneficiaries, requiring them to distribute the entire balance of the inherited account within 10 years following the death of the account owner. The IRS’s finalized regulations provide clarity on how the 10-Year Rule should be applied.

1. Pre-RBD Death: If the account holder passed away before their required beginning date (RBD), NEDBs must distribute the entire balance by the end of the 10^th year following the account holder’s death. No RMDs are required during the 10-year period, but the entire account must be emptied by the end of the 10^th year after death.
2. Post-RBD Death: If the account holder died on or after their RBD, annual RMDs must be taken based on the beneficiary’s life expectancy in years 1-9 after the year of death, with the remaining balance distributed by the end of the 10th year.

The IRS has waived the requirement for annual RMDs for beneficiaries subject to the 10-Year Rule through 2024. However, these beneficiaries must still fully deplete the inherited account by the end of the original 10-year period.

Example: Jane inherited a Traditional IRA from her father, Paul, who passed away at age 80 in 2021. Jane is not required to take RMDs from 2022 through 2024, but she will need to take them from 2025 to 2030, ensuring the Traditional IRA is fully depleted by 2031.

Undistributed Year-of-Death RMDs

If the owner of a retirement account has not fully satisfied their RMD before passing away, the beneficiary must take the remaining RMD by the end of the year. Under the final regulations, an owner’s undistributed RMD can be satisfied by any of the beneficiaries in any proportion they choose, rather than each beneficiary needing to take a proportional share.

However, when the deceased owner had multiple IRAs with different beneficiaries, the undistributed year of death RMD must be taken proportionately from each IRA based on the prior year end values. This means even though beneficiaries of a single IRA can fulfill the RMD in any manner they choose, when different IRAs have different beneficiaries, the RMD must be allocated proportionately across all IRAs. This requirement has raised privacy concerns as it may lead to beneficiaries becoming aware of the total values and distributions across all the inherited IRAs.

Example: Robert has two IRAs: IRA #1 with a prior-year balance of $1,200,000, left to his two children, Jack and John, and IRA #2 with a prior-year balance of $300,000, left to his two nieces, Jane and Marie. Robert’s total IRA RMD for the year is $75,000, but he passes away in February after only taking $10,000.

The remaining $65,000 RMD must be distributed by year-end. Since Robert had multiple IRAs with different beneficiaries and didn’t complete his RMD before passing, the remaining RMD must be taken proportionately: 80% ($52,000) from IRA #1 by Jack and John and 20% ($13,000) from IRA #2 by Jane and Marie.

Automatic Waiver of Year-of Death RMD Penalties

The final regulations give most beneficiaries up until December 31^st of the year following the owner’s death to satisfy the year of death RMD and qualify for an automatic penalty waiver.

Roth Accounts in Employer Plans

Roth accounts in employer plans, unlike Roth IRAs, might be subject to annual RMDs if the participant passed away on or after their RBD and their entire balance was not in a Roth account. These RMDs can disrupt the tax-free growth of the account. To avoid the RMD requirement, beneficiaries can roll over the inherited Roth account from the employer plan to a Roth IRA. This strategy would allow the funds to continue to grow tax-free without the need to take distributions during the beneficiary’s lifetime.

Navigating the IRS’s finalized regulations for Inherited IRAs is crucial for effective estate planning and tax management. Understanding these rules ensures you handle your inherited retirement accounts appropriately, avoiding costly mistakes, and optimizing financial outcomes. Key considerations include:

• Review Your Estate Plan: Revisit your estate plan, particularly your IRA beneficiary designations. Ensure that your chosen beneficiaries align with your current intentions and consider whether the distribution options available are the most tax efficient.
• Plan for Tax-Efficient Distributions: If you are a beneficiary, develop a distribution strategy to help manage minimize the tax impact, possibly spreading distributions to avoid being pushed into a higher tax bracket.
• Explore Roth Conversions: Roth conversions can be a powerful tool to mitigate future tax liabilities for your beneficiaries. By converting traditional IRA assets into a Roth IRA, you pay taxes upfront, allowing your beneficiaries to enjoy tax-free growth and potentially avoid RMDs. This strategy can be particularly beneficial if you anticipate being in a lower tax bracket now than your heirs might be in the future.

The IRS’s updated regulations on inherited IRAs introduce substantial changes that impact how beneficiaries might manage distributions. Eligible Designated Beneficiaries enjoy flexibility in choosing between the stretch method or the 10-year rule, while non-eligible designated beneficiaries face stricter requirements. Understanding these rules, considering tax implications, and planning distributions strategically is essential for managing inherited IRAs effectively. Consulting with financial and tax professionals can help ensure compliance and optimize financial outcomes under the new regulations.