If you have been involved with estate planning in any way over the past two years, you are probably familiar with the overwhelming and complicated process of dealing with inherited accounts. Even in the “simplest” of cases, it’s usually not that simple. Add to that, the ever-changing landscape of IRA legislation over the past two years due to COVID and the SECURE Act, and you’ve got a big mess.
Let’s try to clean this up a bit, shall we?
The 10-year Rule
This was one of the curveballs that the SECURE Act threw all of us in 2020, before the even bigger curveball that the IRS threw us when they “interpreted” the rule earlier this year. It’s a double-whammy of confusion. Here’s how it breaks down:
The 10-year rule became part of the game back in 2020 under the SECURE Act. It eliminated the famous “stretch IRA” which was so beloved by advisors, and replaced it with a new rule which stated that all inherited retirement funds must be withdrawn by the end of the 10th year after the original owner’s death. This was true for most non-spouse designated beneficiaries.
Most financial planners interpreted this to mean: when an IRA is inherited by a non-spouse designated beneficiary, we’ve got about 10 years to plan what to do with it… take it out in pieces over time, or all at once before the tenth year, or some combination. OK. No one expected what came next…
The ALAR Rule
Just as soon as we got used to that idea, here comes the IRS with another detail earlier this year: “oh and by the way, if the original owner’s age is past the required beginning date (RBD), then the inheritor(s) also need to continue taking required minimum distributions (RMDs). Thanks for the tax revenue!”
This is called the “At Least As Rapidly” (ALAR) rule. The IRS has now said that the inheritors of the IRA must continue to take out money “at least as rapidly” as the original owner. So, if the original owner passed away on or after the RBD, then the beneficiary has to keep taking annual distributions, too.
But that also means, if the original owner passed away before they were required to take annual distributions (the RBD), then the beneficiary does NOT have to take annual distributions. Instead, we go back to the original 10-year rule: you can take as much or as little as you like each year, as long as the entire IRA is emptied by the end of year 10. Got it??
Yeah, it seems that very few people are gettin’ it, and it’s no wonder! In this environment, my best advice is to check with a tax preparer or financial planner if/when you inherit accounts, because it can be tricky out there. Here are two more considerations:
Good news for Roth IRA holders: since there are no RMDs for Roths, the ALAR rule need not complicate your financial planning. Instead, focus on the 10-year rule alone. This can be great for inheritors, because assets could continue to grow tax-free for the 10 years, until the requirement that the account be emptied in the final year.
Non-Designated Beneficiaries and the 5-year Rule
So far, we have been mainly focused on “designated beneficiaries.” These are real people that you list on your beneficiary designation form with a financial institution.
However, there is such a thing as a beneficiary who is not a person. If you name as your beneficiary a charity or non-qualifying trust, for example, this can trigger the 5-year rule. Since your beneficiary is an entity and not a person, they are required to take out the money in 5 years, instead of 10. (This often isn’t an issue because charities are usually happy to take a lump sum right away, but it’s something to be aware of in your financial planning).
If you neglect to name a person, or a charity, or designate a beneficiary at all, then things potentially get ugly. Your account will likely become part of your probate estate, which potentially means nasty tax ramifications for your heirs. Also, if you die without a will, your state’s intestate rules will kick in, and someone you may not have intended could inherit your money. Either way, when an estate is the beneficiary of a retirement account, the 5-year rule applies, because it was not inherited by a real person.
Please check your beneficiary designations and be sure they do what you intend them to do. It would be a shame to leave a mess to those you care about, rather than a blessing!
Why All of this Matters
Not taking the correct distributions at the correct time is more than just a paperwork headache. It can also cost you a significant amount of money.
If you don’t take the proper RMD’s from your account, you may be subject to a penalty equal to 50% of the amount that should have been withdrawn. That’s one of the biggest penalties in tax law! For example, if you were supposed to have taken out an RMD of $10,000 and you don’t, you are looking at an additional penalty of $5,000 in addition to the RMD amount. And that’s not even considering taxes. Yuck!
Again, working with a savvy tax preparer or financial planner when you inherit accounts is probably a good idea, to help you stay up on the latest tax rules as well as potentially save you money and headaches.
Want to know more about the types of beneficiaries under the SECURE Act? Read here:
“Are You Leaving a Benefit to Your Beneficiaries? Or a Headache?“