Ed Slott: Confronting RMD Confusion for Inherited IRAs

Key Takeaways

• The Secure Act caps the time nonspouse beneficiaries have to cash out inherited IRAs at 10 years after death, which creates a shorter window for the inherited IRA to be taxed.
• In 2025, the Secure Act will be enacted after five years of delay, and beneficiaries will be required to pay RMDs for a traditional IRA if they inherited it from someone who was over 73.
• With the Secure Act, it may be worthwhile to convert a traditional IRA to a Roth before it is inherited unless you have charitable intent.

Christine Benz: Hi, I’m Christine Benz from Morningstar. The Secure Act and Secure 2.0 changed the rules for inherited IRAs, and confusion has prevailed ever since. Joining me to discuss what people need to know about these accounts is tax and retirement planning expert Ed Slott. Ed, thank you so much for being here.

Ed Slott: Great to be back with you, Christine. Thanks.

New Secure Act Rules for Inherited IRAs

Benz: It’s great to have you here. So I want to talk about the Secure Acts, which changed the rules around for inherited IRAs. Can you give us the Cliff Notes version of these new rules?

Slott: It was a game changer. That’s one tax act that was a game changer. I’ve been studying tax law for over 40 years, and there’s one thing that’s been a constant: Whenever Congress comes up with a name for a tax law, you can almost always bet it will do exactly the opposite. And when I saw the name, the Secure Act, I said to myself, “Hold on to your wallets.” And sure enough, it was a giant revenue grab. They didn’t like the ability of beneficiaries—this is mainly beneficiaries after death, not so much people who are alive that have their own IRAs—but it used to be we had something called the Stretch IRA, where an IRA owner might die, a parent or grandparent—well, they would die eventually [laughter] “might” die—they would die eventually, and their IRA could go out for 30, 40, 50, 60, 70 years if you had a young grandchild deferring it, building up, just taking little crumbs each year and having that account last as a legacy for generations. For some reason, I guess people in Congress didn’t have any kids or grandkids and they didn’t like it. They said, no, enough of that 10-year rule. That changed everything.

Most IRAs that are paid out to nonspouse beneficiaries—forget about spouses; they’re always covered—most IRAs that have beneficiaries as nonspouses, children, grandchildren, so forth, they will have to be cashed out by the end of the 10th year after death. And the rules got so complicated. But really, at the end of 10 years, all of that buildup is going to be taxed. And even if rates don’t go up, that’s going to push anybody’s rate up, to have all that income pushed into one year rather than the old Stretch IRA where you went out little bits, it hardly showed up on a tax return. So now we have a shorter window where all this money piling up in IRAs is going to be taxed.

Why Beneficiaries of Inherited IRAs May Be Subject to the 10-Year Rule in 2025

Benz: There had been a few delays in actually getting this 10-year rule into action. It sounds like 2025 is the year where people have to take this seriously. Can you talk about that? Why this is such an important year for people who are subject to this 10-year rule if they’ve inherited an IRA?

Slott: Yes, again, we’re talking about the nonspouse beneficiaries. If you’re a spouse, this really doesn’t affect you that much. In fact, the Secure Act had better good things than Secure 2.0 for spouses. But the nonspouse, because normally after the parents die, they leave it to their children or grandchildren. So the 10-year rule came out of the Secure Act. And of course, that was one of those that was pushed through Congress at the end of 2019, December, at the end of the year. And it was written so poorly that nobody really knew. Actually, we thought, I thought, I wrote about it. I thought, “All right, the 10-year rule, there’s no Stretch IRA, but the beneficiaries have 10 years to get it out and they could do all their planning, take out whatever they want during the 10 years, as long as it’s emptied by the end of the 10th year.”

Not so fast. Two years later, it took IRS—remember, what IRS does when a tax law is written, it’s not their fault. It’s their responsibility to explain in—I don’t even want to call it English, but somewhere between tax-code writing and English, let’s call it Sanskrit, somewhere between that—they have to explain what they think Congress meant and write regulations that are the authority for how to implement these tax rules. So first they come out—there’s a process. They come out with proposed regulations. Well, they didn’t—it was so complicated—they didn’t come out with proposed regulations until two years later in ’22. And that’s when it hit the fan. That’s when they said, “You know what, we think there’s an old rule in the tax code that we call the “at least as rapidly” rule.” And I’ll explain that in a minute. “And we think Congress, when they put in that 10-year rule, they didn’t take that one away.”

So, in English, what the “at least as rapidly” rule means, if you inherit from somebody that was already taking RMDs that have passed their required beginning date, age 73, April 1 after you turn age 73 is the required beginning date now, so if you are past that date—say you died at age 80, you were already taking RMDs—the beneficiary you leave it to, your children or grandchildren, they will still have to empty it by the end of the 10th year after death. But in addition to that, they will have to still keep taking it out, taking RMDs for years one through nine of the 10-year rule based on their own life expectancy. In essence, that was the old Stretch IRA. So you have this hybrid system where they get a Stretch IRA for the first nine years. And in year 10, it’s 100% RMD. Whatever’s in that account, that’s it. It has to be emptied and taxed.

I just explained it very easily, but this got so complicated that the first year this would have applied—remember, the Secure Act became effective in 2020—so the first year this could have applied for that nonspouse beneficiary would be someone who inherited in 2020. So the first year would be ’21 that they would be subject to that first RMD.

Well, it was so complicated that IRS said, “You know what, forget it, we’re waiving those RMDs for ’21.”

’22 came around. IRS said the same thing. “We still can’t figure it out. All right, we get it. We’ll waive it for ’22.”

’23 came around. Same thing. “We still don’t know what’s going on, even though we’re trying to write the rules. We’ll waive it again for ’23.”

’24 came around. They said, “We’ll waive it again for ’24. But we really mean it this time. It will begin”—and it is—“It’s back in in 2025.”

So then it brought up the question, what about the people who didn’t take one, two, ’21, ’22, ’23 and ’24? Those don’t have to be taken. There’s no penalty for not taking them, but it doesn’t decrease, and that was one of the big questions, the 10-year period. So if you have somebody that inherited, the parents, say, died in 2020, so year one of the 10-year rule would be 2021. So year 10 would be 2030. Now we’re in 2025, so you only have five, six, seven, eight, nine. Is that right? Yeah, five years left because four years you’ve got a free pass to take those RMDs, and in year 10, it still has to all come out.

Now to me, that hurt a lot of beneficiaries because they thought they got a free pass, which they did. But all they did is shoot themselves in the foot. I was telling people, “Take some anyway,” but you don’t have to. They waived it. Isn’t it great? It’s not going to be great when you hit the 10th year and all of a sudden you have $400,000 of income on top of your other income, or $1 million of income. Everything has to come out. What you should be doing is taking advantage of those low brackets. I said you’d be better off trying to smooth out the income, even though it’s not required over the 10 years, to lower your tax bill each of those years for 10 years rather than having the big hit in year 10. So it got very complicated.

Now the other side of that rule is if you inherited from somebody who died before reaching their required beginning date, you don’t have RMDs for years one through nine of the 10-year rule. But I say take them anyway. You know, use up these low brackets, take pieces anyway.

And then there’s another twist for Roth IRAs, inheritors of Roth IRAs. They get a big benefit out of this. Anybody who inherits a Roth IRA under the tax law is deemed to have inherited from somebody who never reached their required beginning date. Even if they died at 99 years old, because Roth IRA owners have no lifetime RMDs.

So technically, whenever they die, they have never reached their required beginning date because there is none. So the benefit Roth beneficiaries have when they inherit a Roth IRA, they can wait till the last day of the 10th year, they don’t have to take anything, and have all that money accumulate tax-free, income-tax-free, every year, pull it all out. The best strategy if you can wait till the end of the 10th year, pull it all out. You still have to pull it out by the end of the 10th year. But all that accumulation, compounding, and growth will be income-tax-free. So it’s a great deal to inherit a Roth IRA.

Differences for Beneficiaries With Inherited IRAs vs. Roth Retirement Accounts

Benz: Just to follow up for people who might inherit IRAs in the future, it sounds like a best practice is to get some tax advice and potentially space out those withdrawals. And then if it’s a Roth, there’s really no harm in waiting until the 11th hour. Is that right?

Slott: That’s right. I would go one step further. I would talk to the parents of the people inheriting and encourage them to convert, even if it costs them money now. Remember, this is taxes. These taxes, it’s not if, but when, it’s not if but when. They will have to be paid. So if they convert to a Roth, the beneficiaries reap the benefits. Beneficiaries always ask, “Can I inherit my mom’s IRA and then convert it?” No, beneficiaries can’t convert an inherited IRA to a Roth. The parents have to do that.

Setting Up Traditional IRA Beneficiaries With the New Rules for Inherited IRAs

Benz: I wanted to ask about that in terms of, we’ve been talking about if you’re an inheritor, some things to think about. Let’s talk about people who have IRAs and they’re naming the beneficiaries for their IRAs. How should the new rules affect their thinking? Because off the top of my head, it’s a little less attractive for a person to inherit my traditional IRA, maybe more attractive if I have charitable intent to earmark those for a charity.

Slott: Right. If you have charitable intent, traditional IRAs are the way to go. Those are the best assets, bar none, to leave to charity. They’re loaded with taxes, but charities don’t pay taxes. So yeah, obviously, if that’s part of the big plan, you don’t need to do anything. Leave whatever portion you want of your traditional IRA to charity or give it to charity during life with qualified charitable distributions if you qualify for those. But also if you want to do something, one question I get a lot from older people, they all say, “I’m 80″ or even 85. “Does it pay for me to convert to a Roth? I mean, does it pay for me to pay the tax during my lifetime, given my shorter life expectancy to reap the benefit?” I said “No, but it depends who you’re doing it for. If you’re doing it for your children or grandchildren, it’s a great move. You’re paying a tax that, if you didn’t, they would otherwise have to pay.” So it’s like a gift, but it doesn’t count as a gift. As long as it doesn’t impact your standard of living, that’s a great move.

Benz: Ed, you are a fountain of wisdom on this topic. It’s been a very confusing area. Thank you so much for being here to clear it up for us.

Slott: Thanks, Christine.

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

Watch The Best Ways to Generate Income in Retirement for more from Christine Benz.