What You Need to Know About Inherited IRAs

Key Takeaways

• The original Secure Act eliminated the stretch IRA and put in place the 10-year rule. What Congress did is essentially downgrade IRAs and 401(k)s as a wealth transfer or estate planning tool because now all of that money for most beneficiaries has to come out within 10 years after death.
• Eligible designated beneficiaries are eligible for different and arguably better treatment. They get the stretch IRA just like before. They are exceptions.
• Many times an IRA owner dies and hasn’t taken the RMD yet for the year of death because many people wait till the end of the year. Under the tax law, death gets you out of pretty much everything except RMDs.

Christine Benz: Hi, I am Christine Benz from Morningstar. Changes to the rules for withdrawals from inherited IRAs have sparked a lot of confusion recently. Joining me to clear some of it up is tax and retirement planning expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back here.

Secure Act and Inherited IRAs

Benz: Well, it’s great to have you. We want to talk about inherited IRAs. There has been mass confusion for a couple of years on these. But the original Secure Act eliminated the stretch IRA and put in place what is being shorthanded as the 10-year rule. Can you talk about that and what the implications are for IRA beneficiaries?

Slott: Yes, that completely upended the estate planning or the wealth transfer planning many people, especially those with larger IRAs or 401(k)s, had been counting on for years, even decades. So, it changed the plans. You know, it’s funny. This is just something that goes on in tax law. I’ve been studying it for 40 years. Any time Congress names a law, you can almost always bet whatever they name it, it will do exactly the opposite. How’s that Budget Reconciliation Act working out?

So, when I saw the Secure Act, when they came originally out with the first Secure Act, I said, hold on to your wallets when I saw the name. And if sure enough, people have been saving and making these plans for their beneficiaries. So, what Congress did is essentially they downgraded IRAs and 401(k)s as a wealth transfer or estate planning tool because now all of that money for most beneficiaries has to come out within 10 years after death. But there’s been iterations on that. We had the Secure Act, and then IRS over a year later came out with regulations saying, well, we don’t think it works that way. They came out with the 10-year rule and then RMDs, required minimum distributions, during the 10 years, then Secure 2.0—there’s just so much going on. It’s really hard to—well, I guess, it’s easy to inherit, it’s hard to know when to take the money out.

So, what you have to know if you’re a beneficiary watching, when did you inherit? Meaning before the Secure Act or after the Secure Act. So, that would be before 2020. If you’re watching this and you inherited in 2019 or earlier, you get grandfathered by the old rules. So, it doesn’t affect you. You still have RMDs, your stretch IRA, that extended payout, if you were a designated beneficiary, meaning named on the beneficiary form. However, if you inherited in 2020 or later, you will generally, except for a few categories, you will generally be stuck with the 10-year rule, meaning all of that money has to come out by the end of the 10th year after death.

Now, if you’re subject to that rule, there’s another subset of rules you have to know. First, you have to know if you’re affected by the Secure Act, if you inherited 2020 or later. And if the answer to that is yes—I sound like one of those computer things: if yes, I think what we call those diagrams with the different shapes—if yes, if you inherited in 2020 or later, then you have to ask yourself another question, when did the person I inherited from, probably mom or grandpa, when did they die? Did they reach their required beginning date, RBD, did they already begin taking RMDs? Or did they die before they began taking RMDs? Now that makes a difference because the IRS in their regulations came out and said—when the Secure Act was so ambiguous on this point, we thought it wasn’t; I thought it was a straight 10-year rule; we talked about that when the Secure Act came out, but apparently not—well, if the IRA owner, mom or dad, like I said, had already begun taking RMDs, they cannot be stopped.

The best way to explain this is, in the IRS language, they feel that once RMDs, the faucet, like a water faucet has been turned on, it can’t be turned off. So, if mom or dad, the deceased IRA owner, began taking RMDs, they cannot stop. You as the beneficiary have to continue taking RMDs through years one through nine of this 10-year rule and still, at the end of the 10 years, everything has to come out.

Now, another complication: How do you calculate those years one through nine RMDs? They’re based on a hybrid system, based on the old stretch rules for years one through nine, based on your own life expectancy, then everything, 100% RMD, whatever is left at the end of year 10, if you inherited from somebody who had already begun. If you inherited from somebody who died, say, before age 73, that hadn’t begun yet, then you don’t have to take any RMDs for years one through nine. You can wait it out and take the whole thing out at the end of year 10. But wait, there’s more. If you inherited a Roth IRA, the rules are different. But the same rules apply if you inherited a Roth IRA before 2020, you have RMDs, you have the stretch IRA on your Roth. If you’re subject to the Secure Act, if you inherited in 2020 or later, inheriting a Roth, then doesn’t matter when the person you inherited that Roth from died, even if they lived till 99 years old, you still get to treat it as if they died before beginning RMDs, because Roth IRAs have no lifetime RMDs. So, that’s a big benefit for Roth IRA beneficiaries. They can hold on to the inherited IRA for the full 10 years. They don’t have to take anything unless they want to. And it can grow income tax-free that accumulates for the full 10 years, and at the end of the 10th year all of that money does have to come out, but it will all be tax-free.

Now this got so complicated IRS said, “Well, back to those people subject to the 10-year rule”—and they did this last year too, don’t worry about it this year. We know it’s complicated, most financial advisors are unsure of the rules. So, if you’re in the group I just said that was subject to RMDs for years one through nine under the Secure Act, this year’s RMD ... what IRS actually said there will be no penalty for not taking it, which essentially means you don’t have to take it. In other words, they’re giving you a reprieve because the rules are so confusing, they said, we’ll start it up again next year.

So, all that said is that now there’s a delay. Let’s say, you did inherit in 2020 and you were subject to the 10-year rule, so you were supposed to begin and inherit from somebody who had already begun, and you were subject to the one through nine years, one through nine RMDs, you were supposed to begin in ‘21, have an RMD in ‘22 and ‘23. Now, all of those have been waived by IRS because they did that last year, that’s a relief, because it got so confusing, and they did it this year. So, if that was you, now you only have seven years left.

But here’s the bigger picture, I think. I don’t know if it’s smart for a beneficiary to wait till the end of the 10th year after death. Even if they can wait or just even if they’re subject to the years one through nine taking smaller distributions, you may want to take more than you have to or withdraw even if you don’t have to, to smooth out the tax bill over the 10 years, so you don’t get hit with the whole shebang at the end of year 10.

Eligible Designated Beneficiaries and IRA Benefits

Benz: Right. That’s good advice, Ed, and it sounds like get some tax advice. I wanted to ask about eligible designated beneficiaries. So, what you just talked about applies to a lot of people who might inherit an IRA, especially children, adult children. But let’s talk about these eligible designated beneficiaries because they are eligible for different and arguably better treatment.

Slott: They get the stretch IRA just like before. They are exceptions. So, the relief I just told you about doesn’t apply to them because it only applies to the people who were subject to the 10-year rule that had RMDs each year. But since the EDBs, the eligible designated beneficiaries, and that’s mostly the surviving spouse and a few other categories—minor children of the deceased IRA owner, not grandchildren, chronically ill, disabled, and beneficiaries not more than 10 years younger than you—they got to continue the stretch IRA, so they don’t qualify for this IRS relief. They still have to take their RMDs this year. So, you have to know what category of beneficiary you are. Are you an EDB or just a regular beneficiary, subject to the 10-year rule? You have to know when you inherited before 2020 or 2020 or later, and if it’s 2020 or later, you have to know whether that person began RMDs or not, unless you’re an EDB, where you get the stretch IRA and then you just continue on your own life expectancy under the old rules. But that’s not most beneficiaries. Most beneficiaries, the children and grandchildren, will be subject to the 10-year rule, but if they’re subject to years one through nine RMDs, that’s being waived for this year.

Year of Death Required Minimum Distributions

Benz: And you say there’s something that people need to pay attention to in the realm of year-of-death required minimum distributions.

Slott: Yes. When an IRA owner eventually they die, and many times an IRA owner dies and hasn’t taken their RMD yet for the year of death because many people wait till the end of the year. So, maybe they were thinking about taking it in December and died before that. Under the tax law, death gets you out of pretty much everything except RMDs. Even after you’re dead, you have to keep taking them, but you’re dead. So, you can’t take them. It’s the beneficiaries’ responsibility. So, the beneficiary has to take that year-of-death RMD. And for that one, it’s a different calculation. It’s based on the RMD the deceased IRA owner would have had to take had he lived, not your life, but you have to take it and pay tax, you being the beneficiary.

But what if the person died, like I said, in December and many beneficiaries, they’re doing other things with the estate and they didn’t get around to taking the RMD. There’s good relief on this one. In this case, under new rules, the beneficiary won’t get penalized if they can’t get that year-of-death RMD out by the end of the year. They actually now have until their own tax return due date plus extensions for that year to get that RMD taken, the year-of-death RMD taken. But since we already talked about the 10-year rule, this has nothing to do with the 10-year rule. This is separate. This is the year-of-death RMD that the deceased IRA owner didn’t take because they died. This has nothing to do with everything I just said on the 10-year rule. So, taking all of this together, you’re looking at me like a deer in a headlight—can you imagine how beneficiaries are going to figure this out?

Benz: No, I can’t. And I appreciate you being here to clear this up. It seems like there is mass confusion about this. We’ve been getting a lot of questions about it. So, thank you so much for being here, Ed. I think you made it a lot clearer.

Slott: I tried.

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

Watch “Should You Invest in Stocks, Bonds, or a 5% CD?” for more from Christine Benz.