Be Aware of These New Rules for Inherited IRAs

Key Takeaways

• Before 2020, if you inherited an IRA and you were a designated beneficiary, you could do what was called a stretch IRA, or an extended deferral, and take RMDs over your life expectancy based on your age. You could defer that out for 20, 30, 50, 80 years. Congress didn’t like that. They thought it was too big of a break. They killed that in the original Secure Act and replaced it with a 10-year window. In other words, they’re saying, “Look, beneficiaries, the party is over, all of these funds have to come out by the end of the 10th year after death.” It was effective for inheritances in 2020 or later.
• The 10-year rule applies to everyone except a special class that Congress named EDBs, eligible designated beneficiaries, who still get the stretch IRA, even though it was eliminated for most others.
• Roth IRA owners have no required minimum distributions during their lifetime, but Roth beneficiaries are still subject to the 10-year rule. But a little advantage if you inherit a Roth: If you’re subject to the 10-year rule, you never have to take years one through nine RMDs, no matter how old you are.

Christine Benz: Hi, I’m Christine Benz from Morningstar. The Secure Act upended some of the rules related to inherited IRAs. Joining me to discuss some of the key questions he receives again and again is tax and IRA expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine.

Rules Regarding Inherited IRAs

Benz: We want to take a look at the rules regarding inherited IRAs, which have changed quite a bit over the past few years. You and I have done a few different segments on this topic. People have questions, questions, questions. So, we wanted to tackle some of the main questions that people have related to the new inherited IRA rules. Starting with what’s called an eligible designated beneficiary. Maybe you can talk about who that is and what the rules are for those people.

Slott: All right. Let me take you back down memory lane because this has been the case now since 2020 actually, and we’re in 2024. But, you’re right, we still get questions, the most common questions, and most common from advisors when their clients ask them. The rules have changed so much. So, let’s go down memory lane and history.

Before 2020, if you inherited an IRA and you were a designated beneficiary named on the beneficiary form, an individual, you could do what was called a stretch IRA, an extended deferral, take RMDs over your life expectancy based on your age. You could defer that out for 20, 30, 50, 80 years. Congress didn’t like that. They thought it was too big of a break. They killed that in the original Secure Act and replaced it with basically a 10-year window. In other words, they’re saying, “Look, beneficiaries, the party is over, all of these funds have to come out by the end of the 10th year after death.” It was effective for deaths—or if you want to put it a nicer way, inheritances—in 2020 or later. And that’s the situation we had.

But then at that point, we thought, “All right, it’s not the worst thing. At least you have these 10 years, and you can take it whenever you want as long as you empty the account by the end of the 10th year after death.” Now, the 10-year rule applied to everyone except a special class of elite that Congress named what you called EDBs, eligible designated beneficiaries, people who still get the stretch IRA, even though it was eliminated for most others. And that’s a special class. But there are five classes, but basically, one big one is the spouse. The spouse could still do anything. The spouse is treated as they were before. So, no problem there. They want to do the stretch, the rollover. That’s not an issue. The other four classes, not so much. You don’t see them as much.

Minor children are on that list. And people mistake that. And they say, “Oh, so what’s the big deal? I’ll leave it to my grandchild. They could go out 70 years.” No. Minor children of the deceased IRA owner, not grandchildren. That’s a misconception, still is. And even so, they only get the exception where they get to do the stretch. So, let’s say somebody leaves it to their 14-year-old child. They get the stretch, but only until age 21. Then they, too, are back on the 10-year rule. That’s the second category.

The third and fourth categories are chronically ill and disabled. And if they meet certain tests, they can use the stretch IRA. The fifth category, maybe there are a few more people in there, nonspouse beneficiaries, not more than 10 years younger than the deceased IRA owner. So, that would be a brother, a sibling, a partner, a friend, something like that. Your older brother or somebody, a little around your age, but not more than 10 years younger. I guess the IRS or the tax law figured—Congress wrote that—Congress figured out they’re close in age. How long are they going to live anyway? Let’s let them have the stretch. And those are the five classes.

But to even be in those classes, the people have to be designated beneficiaries and individuals, not entities like estates, charities, or nonqualifying trusts. So, that means you still have to check beneficiary forms. Even for the EDBs, eligible designated beneficiaries, you still have to qualify to be a designated beneficiary, which is really easy. You just have to name a living person on the IRA beneficiary form. But we see people a little sloppy with that. Even the 10-year rule people. So, everybody else gets the 10-year rule pretty much if they’re a designated beneficiary. But if they’re not a designated beneficiary, they don’t even get the 10-year rule. Then they go to the other rules that apply when you don’t have a designated beneficiary. That’s another whole set of rules that you should never fall into. That means you haven’t updated beneficiary forms. You don’t have a designated beneficiary, defaults maybe to your estate. You have an estate, a charity, a nonqualifying trust. And in that case, then the old rules apply. So, you have all these rules. The old rules apply.

For example, if death is before the required beginning date. So, that brings in another thing. The required beginning date is the age 73, just to simplify it, once you begin taking RMDs. If you die before that and you don’t have a designated beneficiary, everything has to come out by the end of the fifth year after death. If you die after you began taking RMDs, then it comes out over the deceased IRA owner’s—and I love this line in the tax code—remaining single life expectancy. So, what’s the remaining life expectancy of a dead person? Zero. That’s why I always say remaining life expectancy had they lived. We call it really a ghost life expectancy. You can continue, but hopefully, you never hit that category.

Let’s go back to the main people, the 10-year-rule people. That’s going to be most of the children, grandchildren, everybody other than the EDBs, the eligible designated beneficiaries. They have to take the funds out by the end of the 10th year after death, but in early 2022, the IRS threw a monkey wrench into this when they issued proposed regulations, which are still proposed, but they are the rules now. If somebody died after they began taking RMDs, then during the 10 years, you have to take RMDs for years one through nine of the 10-year term, and at the end of 10 years, you take everything. And that is another complication because those RMDs for the years one through nine are based on the old stretch IRA rules, based on you, the beneficiary’s life expectancy, as if you got the stretch for nine years, and then at the end of 10 years, everything has to come out. That’s only if you inherited from somebody who died after starting RMDs.

This got so confusing that nobody to date has been subject to that rule. For three years in a row IRS threw up their hands and said, we’re waiving that for these beneficiaries in ‘21, ‘22, and ‘23, because it got so confusing, as you can imagine. So, the rule is still in effect for ‘24. But what I would say, if you’re one of those beneficiaries, don’t take your RMD if you have to take the years one through nine until late in the year when we’re sure it’s the rule. IRS came out and waived them again last year in July because it got so complicated.

And to add another layer to all of this, we’re only talking about IRAs. If you’re talking about Roth IRAs, it’s a different game. Roth IRA owners have no RMDs during their lifetime, but Roth beneficiaries are still subject to the 10-year rule. But a little advantage if you inherit a Roth—this may be a reason to convert to a Roth and leave your beneficiaries a Roth—if they’re subject to the 10-year rule, they never have to take years one through nine RMDs no matter how old you are. There’s a special rule that says, anybody who dies with a Roth IRA, even at 99 years old, is deemed to have died before their required beginning date because there is no required beginning date for Roths during life. So that means they technically never started. So, the Roth IRA beneficiaries can wait until the end of that 10th year after death with all that growing accumulation and take it all out income-tax-free because you say as the parent or grandparent paid all the tax when you converted, and you left them a Roth IRA.

Remember IRA beneficiaries cannot convert an inherited IRA to an inherited Roth, but in a quirk in the rule, if they inherit a 401(k) for some crazy reason—I think it’s an unintended consequence of the law—if they inherit a 401(k), that can be converted to an inherited Roth IRA. So, it’s this quagmire labyrinth of rules that everybody has to know, and it keeps coming down to me, they’re saying, “How can it possibly be this hard to take money out of an IRA? It’s crazy.”

How to Mitigate the Tax Impact of Required Minimum Distributions

Benz: Right, it certainly is. Ed, I wanted to ask a more general question, which is, if someone has inherited an IRA, and let’s say, they’re not a spouse and they’re subject to this 10-year rule, are there any kind of strategies that they should be thinking about to mitigate the tax impact of those distributions that they have to take?

Slott: Let me give you a perfect example. The big strategy is, yes, other than a Roth. With a Roth, like I said, if you can, hold it to the last day of that 10th year after death because it’s all growing income-tax-free. Other than that scenario, everything will probably be taxable in an inherited traditional IRA. Do you want that giant tax hit as the beneficiary when you may be in your own highest earnings years? Better to smooth it out. Let’s say you inherited from somebody who died before their required beginning date, so you don’t even have RMDs until the last one at the end of the 10th year after death. You may want to look at your brackets and take a little each year to smooth out the overall tax bill rather than getting that giant hit in year 10.

For example, let’s say the people that inherited in 2020 subject to the 10-year rule, right? Now, let’s say they inherited from somebody who already began RMDs, so they were subject to RMDs for years one through nine. But if they inherited in 2020, that’s the first year the Secure Act took effect, the RMDs for years one through nine were waived by the IRS in ‘21, ‘22, and ‘23. So now they only have seven years left. They may want to get more of that income over the seven years, so they don’t have the big hit in year 10.

Benz: Well, Ed, a lot to digest here. I’m sure we’ll have more questions in the months and years ahead. Thank you so much for being here today.

Slott: All right. Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz for Morningstar.

Watch Brace Yourself for Higher RMDs in 2024 for more from Christine Benz.