Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Thoughts about buying a new car or going on a luxurious trip may cross your mind when you receive an inheritance. Yet, not following strict rules could deflate your dreams and inflate your tax bill if you’re not careful. After years of confusion and complaints, the IRS finalized new rules for inherited IRAs. They’re scheduled to go into effect on January 1st, 2025. So, what do you need to know if you inherited an IRA since 2020 or expect to in the future? Denise Appleby is known as The IRA Whisperer. The Morningstar contributor has written about the upcoming changes. Here’s our conversation.
Welcome back to the podcast, Denise.
Denise Appleby: Good morning. How are you? Thanks for having me back.
Hampton: I’m good. I’m feeling good. Congress passed two retirement laws that have raised a lot of questions, Denise. Talk about the concerns that you’ve heard from financial advisors and heirs.
Appleby: So, what you’re talking about is the SECURE Act, right?
Hampton: Yeah.
Appleby: Ivanna, it’s been over four years. The SECURE Act was passed into law on December 20th, 2019. And we had to hit the ground running because most of the rules became effective like a week later. And one of the most significant changes that was made on the SECURE Act 1.0 is they took away the stretch IRA strategy that so many advisors loved to recommend. Now, under the stretch IRA strategy, a beneficiary who was a designated beneficiary – you’re going to hear me use a lot of technical terms here. So, if you fit certain categories, which meaning you’re an individual to be a designated beneficiary, you could take distributions over your life expectancy in most cases. And SECURE Act 1.0 says, nah, this is not your retirement nest egg. It’s just extra money for you. So, now we’re going to put a cap on how long you can allow that to grow tax-deferred, a cap of 10 years, unless you met certain narrowly defined exceptions to be classified as an eligible designated beneficiary, then you can take distributions over your full life expectancy.
Now, here’s what a lot of people miss, Ivanna. Part of the stretch IRA distribution strategy was, let’s say, the beneficiary who inherited the IRA had a life expectancy of 50 years, and they died 10 years in, then the successor beneficiary could continue what remained of the 50 years, which would be a lot of years in this example. SECURE Act 1.0 says, no, even if a beneficiary was taking distributions over their full life expectancy, if they die after 2019, the successor beneficiary now have a maximum period of 10 years. So, it doesn’t matter where you turn as long as the owner or the beneficiary dies after 2019, we have a 10-year maximum period to deal with.
Hampton: And these rules apply to traditional and Roth IRAs, right? What are the similarities and differences when inheriting one?
Appleby: Yeah, I’m so glad you asked that question, because usually when we talk about this, people forget that the RMD rules do apply to Roth IRA beneficiaries and Roth 401(k) beneficiaries. So, the thing to remember is there are two sets of rules. One set of rule applies if the account owner died before they’re supposed to start taking required minimum distributions. That’s referred to as their required beginning date. So, say for instance, someone reaches age 73 in 2024, 2024 would be the first year that they are supposed to take an RMD, but the 2024 RMD can be taken as late as April 1, 2025. And that April 1 date is the required beginning date.
So, here’s what we must pay attention to. And especially if you’re an advisor and someone comes to you and say, I have an inherited IRA, what are my distribution options? They have to ask the question that you just asked. Is this a traditional IRA or a Roth IRA? Because a Roth IRA, the owner is always treated as if they died before the required beginning date. And that’s because Roth IRA owners have no required minimum distributions. So, the rules are if you died before the required beginning date, or if it’s a Roth IRA, the beneficiary has a 10-year period over which they have to distribute the account. Distributions are optional for the first nine years. You’ve got to empty the account no later than the end of the 10th year. So, that’s both for traditional and Roth for designated beneficiaries.
It gets more complicated because if it’s not a regular designated beneficiary, if it’s, say, a non-person, we call them a non-designated beneficiary, it’s reduced from 10 years to five years. If it’s an eligible designated beneficiary, then they have the option of the 10-year rule or they can actually take distributions over their life expectancy. That applies to both traditional and Roth.
Now, when we get into the if the account owner died on or after the required beginning date, that applies only to traditional accounts. Now, here’s where the issue, one of the big issues came in Ivanna. The language in SECURE Act 1.0 suggested that if you were a designated beneficiary and you were subject to the 10-year rule, your distributions were optional for the first nine years, regardless of the account owner’s age at death. And then the IRS published proposed regulations in February of 2022 and said, hang in a second, we have something called the at least as rapidly rule. And under the at least as rapidly rule, once someone has already started taking annual RMDs, you can’t stop. Which means that a beneficiary who was subject to the 10-year rule and inherited an account from someone who died on or after the required beginning date, they have to take annual RMDs. So here we had beneficiaries skipping along saying, oh, I’m a designated beneficiary, I know I have only 10 years, I also know that I don’t have to take annual RMDs. But when we saw those proposed regulations, it created quite a stir because now everyone was saying, no, you’re telling these individuals that they have to take annual RMDs. And guess what? Because a lot of them didn’t, because they thought they didn’t have to, they owe the IRS an excise tax, which used to be 50%. It was reduced to 25% effective 2023.
So that looked like you were set up to fail. So, you could pay the IRS the excise tax. And of course, they got a lot of negative feedback. And in response to that, the IRS said, listen, we know, we agree the language was confusing. So, here’s what we’re going to do. We’re going to waive the excise tax for 2021. And they extended it – 2021, 2022, 2023, and 2024. So RMD, the excise tax for those years were automatically waived, but only for beneficiaries who were subject to the 10-year rule. And there are two classes of beneficiaries who are subject to the 10-year rule – a plain designated beneficiary, right? But if they inherited the account on or after the required beginning date, have to take annual RMDs, excise tax is automatically waived. We also have a successor beneficiary to deal with, where the primary beneficiary was taking distributions over the full life expectancy. When that primary beneficiary dies, then the successor beneficiary must continue for no more than 10 years. They too get the automatic waiver of the excise tax for 2021 through to 2024.
Hampton: Now you’ve brought up the excise tax, and I’m glad you did because that’s a wonderful segue, because many non-spouse beneficiaries, like adult children, want to know if they must withdraw required minimum distribution or RMDs every year. And you said that the IRS waived the penalty for it. What’s the final word now from the IRS?
Appleby: So, the final word is, we’re back on baby. Did you inherit an account from someone who was already taking RMDs? Then you’ve got to take annual RMDs, whether it’s the original account owner or was it a primary beneficiary who was taking annual distributions over their life expectancy. So, the free period is done. In Jamaica, we have a saying, free paper bun, that means you have to go back to school because summer vacation is over. That’s a good comparison here. You have to start taking RMDs come 2025 because the question becomes, what happens if you don’t take your RMDs in 2025? It means that you owe the IRS an excise tax because the period of the automatic waiver has now expired.
Hampton: I also want you to set the record straight about the so-called 10-year rule. Do folks need to withdraw all their money from their inherited IRAs by then?
Appleby: Yes, there’s no extension on the 10-year rule. So, let’s say, for instance, someone inherited an IRA in 2020 and they are a regular designated beneficiary, so they’re subject to the 10-year rule. We know that they get the automatic waiver of the excise tax. So, I’m so glad you asked that question because the issue becomes, now that the RMDs are back on, do they start counting year 10 from 2021 if they inherited the account in 2020? And the answer is yes. The 10-year period is not extended.
Another question that I get, Ivanna, is, okay, I inherited an IRA in 2020. I know that I have to fully distribute the account by the end of 2030. I know that if the account owner died on or after the required beginning date, I have to take annual RMD. But I also know that the excise tax was waived for those four years. Do I have to play catch up come 2025 and take the RMDs for those years that I didn’t take? No, you don’t have to, because remember, the excise tax was automatically waived. So, the 10-year period is not extended. And no, you don’t have to play catch up.
But I usually say talk to your advisor, your tax advisor, about what you should really do because you still have a limited period over which to distribute those assets. So, if you take only the RMDs during the nine-year period or any period before year 10, come year 10, you’re going to have a huge balloon payment that you have to take. And the question becomes, how does it affect you from an income tax perspective?
Hampton: Good point. And why do you think Congress is set our heirs emptying these accounts within a decade?
Appleby: Because they want the income tax from it. The IRS wants to get paid. And one of the disadvantages for the IRS from the old stretch rule is that they get the income tax in trickle amount, little bit amounts every year for people who elect to stretch distributions over their life expectancy. But now under the new rules, the IRS only have to wait 10 years for the account to be fully distributed and so that they get the income tax from tax-deferred amounts. And when it comes on to Roth accounts, then no longer you get that unlimited period pretty much over which you can continue to have tax-deferred growth, which eventually becomes tax-free from a Roth account.
Hampton: Thank you for that. So, Denise, you’re great about including examples in your column. So, let’s work through a couple of scenarios here. What if someone started taking RMDs before they passed? What would be required of their non-spouse beneficiary?
Appleby: Yeah. One of the first things you want to do is determine what class does that non-spouse beneficiary fall into, right? You don’t want to assume that because it’s a non-spouse beneficiary, it’s a regular designated beneficiary. So, check are they a regular designated beneficiary or are they an eligible designated beneficiary? Because if they’re just a regular designated beneficiary, we know they’re subject to the 10-year rule and they have to take annual RMDs. But if they are an eligible designated beneficiary, they could take distributions over their life expectancy. It would be the life expectancy of the beneficiary or the remaining life expectancy of the decedent, whichever is longer. So, there’s no 10-year maximum for an eligible designated beneficiary.
But let me tell you who an eligible designated beneficiary is. The surviving spouse of the account owner, a beneficiary who’s disabled or chronically ill at the time of the account owner’s death, a beneficiary who’s not more than 10 years younger than the account owner. So, an older beneficiary is included in this. And I’m leaving the minor child of the account owner as the last one because there’s a caveat there. If you are the minor child of the account owner, then you are an eligible designated beneficiary and therefore you can take distributions over your life expectancy. But guess what? You’re considered the minor if you’re under age 21. Once you reach age 21, you are no longer a minor. You’re no longer technically an eligible designated beneficiary. So, you have a maximum period of 10 years over which you must continue distributions. That 10-year period starts when you reach the age of 21.
Hampton: And the next example, what if the original account owner died before they were old enough to take their annual payouts? What happens then?
Appleby: Excellent question. Still, you want to ask the question, are they a regular designated beneficiary or an eligible designated beneficiary? Because in that case, if they’re a regular designated beneficiary, they have 10 years. They don’t have to take annual RMDs, but they got to empty the account no later than the 10th year following the year of death. And for a traditional account, Ivanna, the question becomes, do you want to wait until the end of the 10-year period to take everything, right? Because then you have this huge amount that you have to take. Or do you want to spread it over 10 years to manage the tax impact?
Now, for a Roth account, it’s the same thing. But I say, let the money stay in the Roth because it’s going to be tax-free anyway. Let it stay there and maximize the benefit that you can get. Now, if you’re an eligible designated beneficiary, you have that same 10-year rule that I just talked about. But you also can choose to use the life expectancy method where you take annual distributions over your life expectancy.
Now, here’s a tip. Don’t assume that because you do have that option, that that’s available to you. Talk to the IRA custodian or if it’s a 401(k) or other type of employer plan, ask them – what are my options here? Because here’s something that many people miss, Ivanna. The regulations say, oh, if the account owner died before they were supposed to start taking RMDs and you are an eligible designated beneficiary, then you can use a 10-year rule or life expectancy rule. And the regulations default to the life expectancy rule, which is usually the more favorable option in most cases. But the plan document could say, I don’t care. I want you out of here in 10 years. So, we’re going to make sure that you’re subject to the 10-year rule. And when that happens, the beneficiary has options. They can move the account to another account where they’re eligible to take distributions over their life expectancy.
Now, if it’s a 401(k) account or other type of employer plan, you got to make sure you move those assets using the direct rollover method. And you do that by December 31st of the year following the year of death to a beneficiary IRA, emphasis on beneficiary IRA, not your own IRA, that allows you to take distributions over your life expectancy. Now, Ivanna, I just said, you can wait until December 31st, the year following the year of death. That’s a deadline. But that’s the regulatory deadline. Did you know that there are plan documents that says, I want you out of here in 90 days. Can you believe that?
Hampton: No.
Appleby: So, you are a beneficiary. You’re grieving. You don’t have time to be looking at that stuff, right? Because you just inherited an account because someone that you love died. And you’re grieving. You put the paper aside, you’re going to get to it later. And next thing you know, you get a big fact check in the mail saying, here’s your $2.5 million. And I’m using that figure because it really happened to a client of mine. And when you’re a non-spouse beneficiary, and the distribution is sent to you in your name, that’s it. You can’t put the money back. So here you are thinking, oh, I have 10 years, or oh, I can take it over my life expectancy. Turns out you only have one year because you didn’t take action, which is why you got to talk to a financial advisor who’s going to look at the document and see whether or not there are any restrictions that you had a disadvantage and whether or not as beneficiary, you need to take action by certain date in order to maximize the benefits that are available to you.
Let me just say one more thing, Ivanna. The beneficiaries that I just talked about are designated beneficiaries and eligible designated beneficiaries. But don’t forget that there are non-designated beneficiaries as well, such as non-person beneficiaries. And an individual could find themselves being treated as a non-designated beneficiary because they are one of multiple beneficiaries, one of which is a non-designated beneficiaries, and certain action was not taken by September 30 of the year following the year of death.
Hampton: Now, I got to ask about that $2.5 million check. Do you go to a brokerage and say, hey, I need to do a quick rollover, so I don’t get penalized or something?
Appleby: Excellent question. Because you are a non-spouse beneficiary, you can’t roll it over. So, I along with the client’s attorney had to give them the bad news. You are a non-spouse beneficiary. When a non-spouse beneficiary takes a distribution, whether because they sign the form or whether under the terms of the document, they get a distribution that they elect by not electing, if you will. That’s it. They can’t roll it over. A non-spouse beneficiary cannot roll over a distribution that was paid to them.
Hampton: So, the age to take out RMDs could be 73 or 75 if born after 1950, but there’s a quirk beneath. For anyone born…
Appleby: There’s a quirk in it.
Hampton: …in 1959.
Appleby: When SECURE Act 2.0 was signed into law, it changed the starting age for RMDs. It used to be 70.5. SECURE Act 1.0 increased it to 72. And then SECURE Act 2.0 says, hang on a second, let’s put a schedule in place. So, depending on when you were born, it could be 70.5, 72, 73 or 75. Now, for individuals who were born in 1959, they fell into two categories, the age 73 category and the age 75 category. So, here we were saying, you know, which way do we go if you were born in 1959?
Well, the good thing is that that wouldn’t have become an issue for a few years. But when the final regulations were signed into law in July of this year, the proposed regulations were also published on that same date. And what they did was to put a pencil there to pencil it saying, if you were born in 1959, then your starting age is 73. Now, those are proposed regulations, which means when the final regulations are signed into law, that could change. But we don’t have to worry about that for a few years at least. So, we’re okay.
Hampton: I’m sure we’ll talk about it when it becomes final.
Appleby: Yes.
Hampton: So, we’re still in 2024. If somebody give their RMDs between 2020 and now, what should they consider and who should they call?
Appleby: They should call their financial advisor. And they should make sure they start up their RMDs in 2025. And don’t assume because I get this question a lot, even from brilliant professionals, because this is not your area. You don’t know, right? So, I get the question from CPAs and attorneys and financial advisors saying, oh, my client didn’t have to take RMDs in 2021 to 2024. What do they do now? And I’ll say, well, stick a pin in it, before we have this conversation, I want to make sure that that’s true. And in a lot of the cases, when I look at who the beneficiary is, they were a surviving spouse, they were other class of eligible designated beneficiary, meaning not more than 10 years younger. And then I have to say, but no, they didn’t qualify for that automatic waiver. The only types of beneficiaries that qualified for the automatic waiver are regular designated beneficiaries. So, we got to look carefully at the class of beneficiaries to determine the distribution options that are available to them, whether they qualified for the automatic waiver. And we’re also going to look at the type of account as you mentioned earlier. Is it a traditional or a Roth? And if it’s a traditional, did the account owner die on or after the required beginning date?
Hampton: And Denise, your final word, what do you want to leave the audience with?
Appleby: Listen, they have already shortened the period over which you can take distributions as a beneficiary. Don’t put a bonus on it by missing the RMD deadline, because if you do, there’s a 25% excise tax. There’s a new provision that says if you correct it timely, that excise tax is reduced to 10%. But even then, talk to a tax advisor, because the IRS as of now will still waive the excise tax if the deadline was missed due to reasonable error. I’m working on a case right now where the beneficiaries didn’t know that they inherited the account. If they didn’t know, they couldn’t have taken RMDs, right?
Hampton: Right.
Appleby: So, in a case like that, that’s reasonable error. And you don’t pay the excise tax, you have your tax professional file IRS Form 5329 and say to the IRS, listen, here are the facts and circumstances, this is reasonable error, and we’re asking you nicely to waive the excise tax. And in my experience, so far, the IRS have always said yes.
Hampton: That is good to know. Denise, thank you for coming on and explaining the new rules for inherited IRAs that are coming in 2025.
Appleby: Thanks for having me on. It’s a complex issue. Don’t feel like you have to do it on your own, right?
Hampton: Right.
That wraps up this week’s episode. Thanks for listening and making this show part of your day. The Investing Insights team asks that you give our podcast five stars to help others find the work we’re producing for you. Thanks to Senior Video Producer Jake VanKersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.