An individual retirement arrangement (IRA), or more commonly referred to as an “individual retirement account,” is a tax-deferred investment account that helps you save for retirement. Tax laws that impact IRA distributions are quite complex. This is especially true for those that control Required Minimum Distributions (RMDs). IRAs are tax-deferred accounts, which means that income taxes are only owed on amounts taken out of the IRA*. With that said, the IRS generally requires you to make distributions from these IRAs, particularly after you (or the account owner) turn age 72 (or age 70 1/2 if before January 1, 2020). If you inherit an IRA, the age requirement may be even lower. Since different RMD rules apply when the account is inherited, the amount and timing of these distributions depends on your relationship to the account owner.
For example: What if you inherit an IRA from a friend, relative, or family member?
For the purposes of this article, we are focusing on “non-spouse beneficiaries.” In other words, someone who is designated as the beneficiary of the IRA, but is not the account owner’s spouse. Historically, non-spouse beneficiaries have had several options. These options included the ability to “stretch” the RMDs out over their life expectancy. Most recently, in 2020, the SECURE Act modified these rules to ensure that many of these inherited IRAs were fully distributed within a more specified time frame. Essentially, a non-spouse beneficiary who inherits an IRA from someone who passed away after December 31, 2019, must distribute the entire inherited IRA by December 31st of the 10th year after the decedent’s passing (the “10-year rule”).
DO I NEED TO TAKE DISTRIBUTIONS ANNUALLY, OR CAN I WAIT UNTIL YEAR 10 TO DISTRIBUTE THE ENTIRE IRA?
Delaying inherited IRA distributions could be tax efficient for multiple reasons. If the beneficiary is still working (high income tax bracket), they may choose to wait to liquidate it. This may be because they will be retiring in 9 years, and thus in a lower income tax bracket. The good news is that current common interpretation of the law does not require annual distributions from an inherited IRA. The only requirement is to liquidate the entire IRA within 10 years.
However, in February 2022, the IRS issued proposed regulations surrounding inherited IRA distributions. These regulations state that if a non-spouse beneficiary inherits an IRA from someone who had already begun taking their RMDs, the beneficiary must follow the 10-year rule and take annual distributions. The annual RMD amount was not specified. These proposed regulations are not yet final, nor signed into law. Thus, non-spouse beneficiaries still have the option to take annual distributions or to liquidate the IRA within 10 years.
CONCLUSION
If you inherit an IRA, we recommend reaching out to your tax advisor to determine the most tax-efficient distribution strategy for you. In the interim, we anxiously wait to see whether the IRS’ proposed regulations will be signed into law.
*For purposes of this article, we are excluding Roth IRAs, which are generally tax-free IRAs.
Author: Marc Verdi, CPA, CFP® | Director of Tax & Financial Planning
Written: October 21, 2022