Kiplinger new inherited IRA rules

An inherited IRA is a valuable financial tool for people who inherit retirement assets from a deceased loved one. However, recent legislative changes brought about by the SECURE Act 2.0 have made managing inherited IRAs more challenging, especially for beneficiaries who are unfamiliar with tax laws.

One of the new inherited IRA rules highlighted by Kiplinger is the stricter 10-year rule for non-spouse beneficiaries, which replaced the stretch IRA strategy. Under the new rules, some beneficiaries are required to take mandatory annual distributions if the original IRA owner had started taking required minimum distributions.

What is the SECURE Act 2.0?

The Secure Act 2.0 (Setting Every Community Up for Retirement Enhance Act) of 2022 expands the original SECURE Act of 2019, and it was signed into law in December 2022. The primary goal of the new law is to expand retirement savings for American workers, including part-time workers, and it introduced several reforms that enhance access to retirement savings.

SECURE Act 2.0 was introduced to clarify certain provisions that were contained in the earlier SECURE Act. It also introduced new changes that directly impact retirement savings plans, including IRAs, 401(k)s, and Roth 401(k)s and IRAs. For example, the SECURE Act 2.0 raised the minimum age for required minimum distributions (RMD) from 72 (under the SECURE Act) to 73.

What is an inherited IRA?

An inherited IRA is a type of IRA that is opened when a beneficiary inherits an IRA or employer-sponsored retirement account after the original account holder dies. The beneficiary is required to open an inherited IRA where the inherited assets are deposited. This allows the money to continue growing tax-deferred, as they figure out how to manage withdrawals.

Two types of beneficiaries can inherit an IRA i.e. spousal beneficiaries and non-spousal beneficiaries. A spousal beneficiary is the surviving spouse of the deceased IRA owner, and they can roll over the inherited IRA into their own IRA, and treat the money as their own. Non-spouse beneficiaries may include children, relatives, and non-relatives of the deceased IRA owner, who must manage distributions based on certain IRS rules.

The 10-year rule for non-spousal beneficiaries

The SECURE Act 2.0 introduced stricter rules for non-spouse beneficiaries, especially with the introduction of the 10-year rule to replace the stretch IRA option.

Unlike spousal beneficiaries, non-spouse beneficiaries are not allowed to treat the inherited IRA as their own, and cannot rollover the inherited IRA into their IRA. Instead, they must empty the inherited IRA within 10 years of the account owner's death.

If you inherited a traditional IRA from the deceased IRA owner, you will owe income taxes on the distributions you take. Taking a lump-sum distribution in a particular year can result in a significant tax bill since the distribution will push you to a higher tax bracket. However, staggering distributions over the 10-year period can help you reduce the tax bill for each tax period.

Under the SECURE Act 2.0, Kiplinger reports that, if the original IRA owner had started taking RMDs, non-spouse beneficiaries must take annual mandatory distributions during the 10 years, instead of waiting until the 10^th year to deplete the account.

10-year rule for inherited Roth IRAs

Non-spouse beneficiaries who inherit a Roth IRA are subject to the 10-year rule. The IRS requires these beneficiaries to take distributions over 10 years, as long as the account is fully withdrawn by the 10^th year.

If the deceased IRA owner had started taking RMDs, the beneficiary is required to take mandatory annual distributions. However, if the original IRA owner had not started taking RMDs, the beneficiary is not required to take annual RMDs but must deplete the account within 10 years.

Be aware that qualified Roth IRA distributions are generally tax-free, and the beneficiary won’t be required to pay income taxes on the distributions. However, if the original IRA owner held the Roth IRA for less than 5 years, distributions from the account will be subject to income taxes.

Exceptions to the 10-year rule

While non-spouse beneficiaries no longer get the stretch IRA option, some non-spouse beneficiaries are exempted from this rule.

Eligible designated beneficiaries including minor children, disabled individuals, chronically ill individuals, and beneficiaries who are not more than 10 years younger than the deceased account holder may still stretch distributions over their lifetime.

However, once minor children reach adulthood, the 10-year rule kicks in, and they must withdraw the remaining balance within a 10-year period. For example, if the minor child is 10, they can utilize the stretch option between ages 10 to 21. Once he reaches 21, the 10-year rule will apply, and he must fully withdraw the balance by the 10^th year.

New IRS rules on spousal beneficiaries

Spouse beneficiaries enjoy greater flexibility with an inherited IRA than non-spouse beneficiaries. A surviving spouse can roll over the inherited IRA into their own IRA, which allows them to treat the inherited assets as their own. In this case, they can delay taking RMDs until they reach age 73.

The SECURE Act 2.0 increased the RMD age from 72 to 73, and it is expected to increase to 73 by 2033.

A surviving spouse can also choose to keep the inherited IRA and take distributions based on the original IRA owner's age. The SECURE Act 2.0 clarified that surviving spouses can delay RMDs until the year when the deceased spouse would have turned 73. So, if the deceased spouse had 8 years left to reach the RMD age, the surviving spouse can avoid the annual distributions for 8 years until the RMDs are due.

Waiver of penalties for Inherited IRAs

Based on the Secure Act of 2019, beneficiaries believed they could wait until the 10^th year to deplete inherited IRAs.

However, the IRS clarified this confusion, stating that if the original IRA owner died on or after the date they were to take RMDs, the beneficiaries must take annual distributions on the original IRA owner’s life expectancy starting from year one to nine, and deplete the inherited IRA balance by the 10^th year.

The SECURE Act 2.0 waived penalties for beneficiaries who did not take an RMD from an inherited IRA in the years 2021 to 2024. However, these beneficiaries must start taking RMDs in 2025, and deplete the account within 10 years of the original account owner’s death. The penalty for missing an RMD is 25% of the distribution amount you should have taken, but it will be reduced to 10% if you withdraw the missed RMD within two years.