Beware the Changes in Retirement Account RMD Rules

If you inherited an individual retirement account from someone who died passed away in the last two years,  recent changes in federal tax rules could affect how the withdrawals known as required minimum distributions, or RMDs are mandated.

In 2020, the Internal Revenue Service (IRS) began requiring most new inheritors who aren’t spouses or minor children of the deceased to empty the inherited retirement account over 10 years, rather than continuing to allow those inheritors to stretch out withdrawals over their own expected lifetimes. The IRS, however, didn’t indicate whether these inheritors had to make a minimum withdrawal each year, and many people were confused about whether they had to take annual amounts.

In May of this year, the IRS clarified in a rule revision (Publication 590-B (2020)) that while the new 10-year rule stays in effect, there is no requirement to take an annual RMD during those 10 years. The inheritor can even withdraw the full amount in the first year, or wait until the 10th year, thus giving the assets more time, potentially, to grow.

To know if the 10-year rule and the recent change apply to you, you have to know in which of two categories you fall according to the 2020 Secure Act (Setting Every Community Up for Retirement Enhancement). The act says that individuals who inherit an IRA are considered either eligible designated beneficiaries or designated beneficiaries.

Each category has different requirements for withdrawing funds from the inherited IRA.

1. Eligible designated beneficiaries

For eligible designated beneficiaries, the old rules from before 2020 remain in effect. To be considered a member of this category, the beneficiary must be a living person who fits into one of five classifications: a surviving spouse, a minor child of the account owner but not a grandchild, a disabled person, a chronically ill person or someone not more than 10 years younger than the original IRA holder.

These individuals can still stretch, or spread out, annual required payouts over their lifetime, based on the IRS life-expectancy tables. A spouse beneficiary, moreover, can even delay taking RMDs from an inherited IRA until the year in which the deceased person (known as the decedent) would have had to begin doing so.

For some beneficiaries, that could mean many decades during which the assets in the inherited IRA can grow on a tax-deferred basis.

2. Designated beneficiaries

It is a different, some-what more complicated story for designated beneficiaries, a category that includes most nonspouse beneficiaries such as older children, grandchildren and others. Designated beneficiaries who inherited before January 1, 2020 are grandfathered under the old rules and can still stretch. But designated beneficiaries inheriting after that date don’t have the ability to do that.

Instead, they must empty the entire account by the end of the 10th year after the death of the original account holder. Any amount that remains in the account after that is subject to a 50% missed-RMD penalty.

However, designated beneficiaries do have total flexibility in choosing the amount, frequency and timing of withdrawals based on lifestyle and tax-planning needs, as long as the account Is fully depleted by Dec. 31 of the 10th year following the death. For instance, if you inherited an IRA in 2020 and were laid off in 2021, it may be advantageous to take a larger withdrawal this year when you could be in a lower tax bracket.

The released revision of  IRS Publication 590-B, “Distributions from Individual Retirement Arrangements (IRAs),” which was issued as a guide to preparing tax returns, made it clear that designated beneficiaries don’t have to take RMDs in years one to nine. Voluntary distributions of any amount can be taken during any year in the 10-year period.

A very important note, when making withdrawals from an inherited IRA, remember that the decision is irrevocable. After a distribution is taken, it can’t be put back.

For more information on IRAs or other US tax matters, please contact Ariel Katz at Grant Thornton Israel.  Ariel can be reach at 03-710-6644 or ariel.katz@il.gt.com.