The IRS Throws a Curveball on Rules for Inherited IRAs

The IRS may be switching up the regulations for inherited IRAs once again. If it feels like playing a game with a friend who changes the rules as they go, trust your instincts. And unfortunately, like playing with your “clever” friend, these new rules aren’t designed to benefit you.

Here’s the scoop. On February 23, 2022, the IRS released proposed regulations pursuant to the SECURE Act (aka the Setting Every Community Up for Retirement Enhancement Act), which was passed by Congress in 2019. Included in the act is the elimination of stretch IRAs for all but a handful of exceptions. The new surprise is how the IRS is interpreting the law.

First, let’s review what “stretch IRA” means. If you’re not familiar with the term, a stretch IRA is actually a strategy, not a type of account. It refers to an heir’s ability to stretch out their distributions, thereby lessening their tax burden (and allowing the money to continue to grow tax-free). When someone inherits an IRA, they must take required minimum distributions (RMD) just as the original owner did. The RMD amount is calculated based on the balance of the account and either the original account holder’s age or the heir’s age, depending on the heir’s preference. The latter option was beneficial because smaller RMDs meant a lower tax burden and a longer time for the account to continue to grow tax free—especially if the heir was a grandchild.

The SECURE Act changed that for deaths occurring in 2020 or later. Now heirs must withdraw the entire amount of the IRA within 10 years. The only exceptions are a surviving spouse, heirs who are no more than 10 years younger than the descendent, minor children of the descendent, or someone who is disabled or chronically ill. They can continue to have a stretch IRA in the original sense. Everyone else is now limited to a 10-year stretch.

Now back to the IRS. Originally, it seemed the provisions of the SECURE Act would be interpreted in such a way that you would only be required to liquidate the account by year 10. Until then, you could leave it untouched if you wanted. However, under the regulations published in February, if you inherit an IRA from someone who had already started taking RMDs, you must continue to do so annually. That means no waiting until the 10^th year to withdraw all the money. You’ll have to take RMDs every year for the next 9 years. Anything that’s left must be distributed in year 10.

What does that mean in practical terms? It means it’s a tax mess. If your kids inherit your IRA in their peak earning years, they won’t have the luxury of waiting until they’ve reached retirement to make withdrawals at the lower tax rate.  Worse, if you’re not following this news closely and miss a RMD on an IRA inherited after 2020, you could get hit with a 50% penalty on the amount you should have withdrawn.

Now, it’s important to note that if the account you inherited is a Roth IRA, you’ll have some options, because RMDs aren’t required since it’s a post-tax account. But you’ll still have to withdraw the entire balance by year 10.

The IRS is taking public comments on the proposed regulations until late May. A public hearing will be held on June 15, 2022. In the meantime, it’s important to engage a professional to assess how the proposed changes could affect you and your loved ones. Planning in advance could prevent an unduly large tax bill. Here at Golden Reserve, our experienced on-staff tax professionals will be keeping an eye on the developments to  protect our clients. Let us look out for you, too. Schedule a no-cost, no-obligation consultation with one of our retirement planners.