Today, we’re going to explore a topic that you likely either know a lot about or absolutely nothing about – as it’s something that usually “only matters when it does.” That is the 10-yr rule for inherited IRA distributions, particularly as they relate to non-spouse beneficiaries (technically referred to in the rules as a “designated beneficiary”). This new rule originally came about via the SECURE Act passed in late-2019, effective January 1, 2020 – but has been shrouded in confusion since the day it passed. After roughly 4-1/2 years, the IRS has finally clarified the rules in a 260-page memo (available upon request!). I’ll resist the urge to list all the major events that have happened in the interim!
So, with these rules now firmly in place, let’s look at what it means for these designated beneficiaries, as well as IRA account owners as they consider their own estate plan. Note that we’re not going to dive into the rules on spousal beneficiaries and other “eligible” designated beneficiaries, as those rules are distinctly different and warrant a paper of their own. Our focus will be on designated beneficiaries, as that is where most of the confusion has been, and because getting into the weeds on some other more nuanced situations will make this piece unbearably long. We’ll look at both Traditional IRA (and 401(k)) accounts, as well as Roth IRA (and 401(k)) – as the rules are different, as the distinction is important.
Before we go any further, here’s a snapshot of the distinction between a “designated beneficiary” and an “eligible designated beneficiary.” Couldn’t they have come up with more distinct terms?
Source: Morningstar, Denise Appleby (July 22, 2024)
With that long intro behind us, let’s dig into the details. To best illustrate this, we’ll look at two hypothetical examples.
SCENARIO 1
In the first scenario, we’ll assume your father just passed away in June 2024 at the age of 86 and you (age 56) are the sole beneficiary of both his Traditional (pre-tax) IRA account and his Roth (after-tax) IRA account. The Traditional account is worth $1 million upon his death, while the Roth is worth $500,000. What is next for you with each of these? To understand the rules, it’s important to understand the fact pattern:
- Deceased account owner’s age = 86, which means he already had started taking his RMDs
- Your age = 56 (born 1968), which is >10 years younger than the deceased, making you a “designated beneficiary”
- Account type = Both Traditional and Roth, which means two sets of rules will apply
Because you are a designated beneficiary and your father had already started his RMDs[1], you are subject to the 10-year rule with RMDs included. What does this mean? The 10-yr rule simply means that the entire account has to be liquidated by end of the 10th year following death, with the clock starting on January 1 of the year following death (2025 in this case). In other words, the account balance must be $0 on December 31, 2034. This part has been pretty clear since the SECURE Act originally passed. Where the confusion sat was with the “with RMDs included” portion. The IRS’ recently published guidance confirming that if the account owner had started RMDs prior to death, the designated beneficiaries must continue these RMDs, but under their own life expectancy rules (rather than those of the deceased). Sparing you the details, this means you (age 56 currently) will divide the 2024 year-end account balance by 29.8 to determine your RMD for 2025, and then add 1 to this divisor each year for 10 years. If the account balance grew to $1,050,000 by the end of 2024, your RMD in 2025 would be $35,234,90 (all of which is taxable as ordinary income).
Note that if you only take the RMD, you will not exhaust the account by the end of year 10. You will have a lingering balance, perhaps a large one, to contend with in year 10, which might trigger some significant tax issues (as the entire distribution will be taxable as ordinary income). This, in our opinion, necessitates careful financial and tax planning throughout the 10-yr life of this inherited IRA to ensure you maximize its value and minimize the related tax burden.
What about that Roth IRA? The 10-yr rule also applies to it, but no RMDs apply along the way. This is because your father (the deceased) would never have been subject to RMDs with his own Roth, so there is no need to continue such non-existent distributions. Instead, you simply have to have a $0 balance by December 31, 2034, just like you do with the Traditional account. Because this account will grow tax-free and all distributions are tax-free, it is generally best to wait until the very end to take it all out in a single lump sum. That said, there are circumstances where some tax-free income along the way may benefit you, so careful financial and tax planning is warranted here just the same as it was with the Traditional account.
SCENARIO 2
In the second scenario, we’ll assume your father just passed away in June 2024 at the age of 68 and you (age 38) are the sole beneficiary of both his Traditional (pre-tax) IRA account and his Roth (after-tax) IRA account. As before, the Traditional account is worth $1 million upon his death, while the Roth is worth $500,000. What is next for you with each of these? To understand the rules, it’s again important to understand the fact pattern:
- Deceased account owner’s age = 68, which means he was not yet subject to RMDs
- Your age = 38 (born 1986), which is >10 years younger than the deceased, making you a “designated beneficiary”
- Account type = Both Traditional and Roth, which means two sets of rules will apply
In this case, the same 10-yr rule applies, but no RMDs are required during this time. You, as the inheriting account owner, must simply ensure the account balance is $0 by December 31, 2034. You can take periodic withdrawals of any amount, or simply wait and take a lump sum on the final possible day. What you choose will depend on your financial needs and tax considerations. Regardless, as in scenario 1, every dollar that comes out of the inherited Traditional IRA will be taxable as ordinary income.
The situation with the Roth IRA is exactly the same as in scenario 1.
WHAT IF I HAVEN’T BEEN TAKING RMDs FROM MY INHERITED ACCOUNT?
Recognizing the confusion that resulted from the ambiguity over all of this, the IRS has waived for 2021-2024 any excise taxes that would otherwise be owed on missed RMDs (from inherited accounts only). These would otherwise amount to 25% of the missed amount. Inherited account owners could have taken withdrawals during that time at their discretion but were effectively not required to do so. However, that is changing for 2025, so you should be prepared (we’ll help you with the calculations!). Note that the 10-yr clock doesn’t suddenly start in 2025. It’s been ticking this entire time. For example, if the original account owner died in 2020, the clock still started in 2021 and will finish at the end of 2030, even though RMDs may only be “required” for 6 of those 10 years.
WHAT IF THE ACCOUNT WAS INHERITED BEFORE 2020?
If you inherited your IRA any time prior to 2020, everything you read here is a moot point! The old rules, under which you “stretch” the distributions over your remaining lifetime, continue to apply. Note that these rules apply on an account-by-account basis, so if one account was inherited in 2019 and one in 2020, you’ll be dealing with two different sets of rules and calculations.
HOW DOES THIS IMPACT ESTATE PLANNING?
If you are reading this from the perspective of an original account owner (as opposed to an inherited account owner), you may have picked up on the fact that the 10-yr rule makes a Traditional IRA a potential tax bomb for your heirs. Adding potentially hundreds of thousands of dollars to your beneficiary’s taxable income, on top of their already existing income, can trigger very high marginal tax rates, thereby eating up 40%+ of the account in the form of taxes. Whereas prior to 2020 inheriting a Traditional IRA was a very favorable asset to receive, the tides have reversed, and such an account is now the least favorable asset to inherit in most circumstances. If you are considering generational wealth transfers and how to minimize taxes over multiple generations, you may be inclined now to:
- Spend down your Traditional IRA relative to other assets while you are still alive, including through Qualified Charitable Distributions (QCDs).
- Consider Roth conversions during your lifetime.
- Be selective about which heirs receive which accounts, depending on their own tax situation.
Of course, there are exceptions to all of this, and careful financial, estate, and tax planning needs to be considered in every circumstance.
LET’S WRAP IT UP
This is unmistakenly a confusing patchwork of rules, for which we have only scratched the surface. We wish things weren’t this complicated, but they are what they are. Since this 10-yr rule gets money into the government’s hands sooner, it’s unlikely this new configuration is going to change. Thankfully, good planning can alleviate the stress and added financial burden that can accompany these new rules. Please reach out to us at any time if you want to explore ways to make the most of your retirement accounts, whether you are the original owner or the inheritor
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[1]Technically, he had to be past his “Required Beginning Date” (RBD), which is generally April 1 of the year following the calendar year the original account owner (your father, in this case) reaches age 73 (soon shifting to age 75). For all intents and purposes, if someone has started their RMDs, they are likely past their RBD, but there can be exceptions and you will be wise to confirm whether that’s the case for you.