IRS Updates Rules for Inherited Retirement Accounts

By Nils Peter Johnson
Johnson & Johnson Law Firm

YOUNGSTOWN, Ohio – For many years, at the death of an IRA owner, the beneficiaries could stretch withdrawals from the inherited IRAs over their lifetimes, allowing for smaller, more tax-efficient distributions and greater growth potential.

In 2019, the Secure Act largely eliminated “the stretch,” mandating a 10-year withdrawal period. However, the Secure Act was unclear about whether annual withdrawals were necessary during the 10-year period or if the inheritor was merely required to withdraw all of the funds by the end of the 10th year.

Recently, the IRS finalized rules to clarify that people who inherit retirement accounts must withdraw funds over a 10-year period, with many required to take minimum annual withdrawals. The new rules apply to 401(k)s, IRAs and other pre-tax contribution plans inherited on or after Jan. 1, 2020.

IRS determined that Congress intended for annual withdrawals to be required. If the deceased was already taking required minimum distributions, the heir must start taking annual withdrawals beginning the year after the death. This primarily affects children and other heirs such as grandchildren, siblings and friends. The IRS guidance affects future inheritors and those who have inherited accounts since 2020, who have been waiting for clarification.

The new rules do not apply to spouses or to those who inherit accounts from someone who died before the age for required minimum distributions, currently set at 73. If the deceased was not yet required to take required minimum distributions, heirs can withdraw the funds at any time within the 10-year period, including waiting until the final year.

Withdrawals from traditional retirement accounts are taxable, so heirs should be cautious about taking only the minimum distribution each year, as this could result in a large, taxable balloon distribution in the final year.

For example, an IRA valued at $100,000 in 2020 with a 5% return would grow to $121,550 by 2025, requiring a $4,000 withdrawal that year. If the heir continued minimal withdrawals, the final distribution in 2030 could be $151,000, pushing him into a higher tax bracket.

Heirs dealing with multiple IRAs face additional complexity, as different accounts may have varying payout rules. For instance, heirs must navigate different life expectancy calculations for their own IRAs and those inherited from others. The most advantageous IRA to inherit is a Roth IRA, as heirs are not required to take distributions until the 10th year, and withdrawals are generally tax-free.

As a matter of estate planning, IRAs and 401(k)s are best understood as future income tax liabilities to the beneficiaries. When considered in this light, owners of these tax-deferred accounts sometimes elect to designate lower-earning individuals as the beneficiaries of these accounts, while leaving other assets (i.e. those without a corresponding income tax liability) to higher earners. 

Although this can result in unequal sums going to the beneficiaries, the very nature of tax deferred accounts makes a fully equitable distribution among beneficiaries with different earning capacities all but impossible.  

In all events, as an asset class, tax deferred accounts have many strings attached to them.  As account owners reach their required minimum distributions birthdays, they should consult with a financial adviser to plot their future withdrawals, and also to sketch-in the income tax liability to those individuals identified as beneficiaries on the account. 

Copyright 2024 The Business Journal, Youngstown, Ohio.