Beneficiaries of Inherited Retirement Accounts Dodge a Tax Bullet

Before the passage of the Secure Act in late 2019, beneficiaries of inherited retirement accounts—such as IRAs, 401(k)s, 403(b)s and 457s—had to take required minimum distributions, or RMDs, each year that were based on their life expectancies. If a beneficiary was younger, the RMD amounts would be lower because of their longer life expectancy. The term “stretch IRA” emerged, defining the practice of extending an inherited IRA over many years.

“This was a powerful strategy to defer taxes and distributions as long as possible,” said Eric Bronnenkant, a CPA and head of tax at robo-advisor Betterment. “Notably, taxpayers who inherited retirement accounts before 2020 are grandfathered into the old rules.”

But the Secure Act made some major changes. It required that noneligible designated beneficiaries must liquidate the assets of an inherited retirement account within 10 years. The IRS defines these beneficiaries as anyone other than “a surviving spouse, a disabled individual, a chronically ill individual, a minor child, or an individual who is not more than 10 years younger than the account owner.”

In late February 2022, the IRS at last issued its proposed regulations on RMDs for inherited retirement accounts. The department stated that not only must beneficiaries liquidate the assets within 10 years, but they must make a distribution—based on life expectancy—for each year of the 10-year term. If not, they would be subject to an onerous 50% excise tax on the amount that should have been withdrawn.

“Since taxpayers and their advisors did not see this rule coming, and further since the regulations aren’t even final yet, it’s unlikely many of the beneficiaries took the required distributions,” said Steve Parrish, co-director of the Center for Retirement Income at The American College of Financial Services. “Unless these taxpayers had a time machine—or a mole inside the Treasury—it’s hard to see how they would know the unknowable.”

To remedy this situation, the IRS published a notice last week. “It suspended enforcement of the proposed regulations until January 2023 at the earliest,” said Adam Frank, head of wealth planning and advice at J.P. Morgan Wealth Management. “No excise tax will be assessed for people who inherited IRAs after 2019 and did not take a minimum distribution in 2021 or 2022.”

And what if you happened to pay an excise tax? You can file an amended return to obtain a refund. 

Regardless of the tax relief, this does not necessarily mean your clients should forgo distributions for the time being. “For beneficiaries who find themselves in a lower tax bracket, it can make sense to start taking inherited IRA distributions,” said Kevin J. Brady, a CFP and vice president at Wealthspire Advisors. “Otherwise, they might find themselves required to take larger distributions in later years that push them into a higher tax bracket.”

Keep in mind that the final rules for inherited retirement accounts are still not settled. But the IRS is likely to issue them by the end of the year or in early 2023.

But if the government decides to require annual distributions in the final rules—which seems likely—there are some estate planning considerations to consider. One is a Roth conversion prior to death, so that your beneficiaries inherit a Roth IRA. Converting a traditional IRA to a Roth entails an immediate tax hit, but future withdrawals are tax free. 

“This may make sense for parents that are in a lower tax bracket than their children,” said Michelle J. Gessner, a CFP and owner of Gessner Wealth Strategies. “Otherwise, these funds will inevitably pass to survivors who will be subject to these tax rules, which effectively distribute about 40% of the money to the IRS instead of allowing it to stay in the families who own them.”

Tom Taulli is a freelance writer, author, and former broker. He is also the author of the book, The Personal Finance Guide for Tech Professionals. 

Write to [email protected]