Navigating ever-changing tax rules on IRAs

As laws and IRS guidance evolve, it’s crucial for advisors to stay on the leading edge of how inherited IRAs are affected.

It’s no exaggeration to say that every time you turn around lately, there’s a new tax law or piece of IRS guidance that changes the tax and distribution rules for IRAs. Based on questions we’re receiving regularly from financial advisors, it’s clear advisors need to enhance their IRA tax planning knowledge to better address their clients’ situations. That’s especially true when it comes to inherited IRAs.

The most common thing we hear from advisors at our training programs is that they didn’t know how much they didn’t know, or worse, that they’ve already given a wrong answer to a client or beneficiary that can’t be fixed.

The inherited IRA distribution rules aren’t only constantly changing but are among the most complicated in the tax code. Worst of all, many of these rules are rigid and can’t be undone if they’re violated, often resulting in serious financial consequences for the client or their beneficiary (the advisor’s new client).

As an advisor, you do not want this happening on your watch!

Consider this list from just the past few years:

The SECURE Act, enacted in December 2019, eliminated the stretch IRA for most non-spouse beneficiaries and replaced it with a 10-year payment requirement.
Effective for 2022 required minimum distributions, the IRS updated its life expectancy tables used to calculate lifetime and inherited IRA RMDs.
In February 2022, the IRS issued proposed SECURE Act regulations that require certain beneficiaries who are subject to the 10-year rule to also take annual RMDs.
In October 2022, the IRS released Notice 2022-53, which waived the penalty for missed 2021 and 2022 RMDs for those originally subject to the annual RMD requirement.
In December 2022, SECURE 2.0 Act of 2022 was passed. Among other items, this legislation delayed the required beginning date for RMDs, reduced the penalty for missed RMDs, and established a three-year statute of limitations for missed RMD penalties.

Considering the number of changes that have occurred in such a short period, it’s no surprise that a great deal of confusion has ensued. As these changes have unfolded, we have fielded thousands of questions from advisors. Here are our answers to the three most common of these questions.

1. Who takes the year-of-death RMD, how is it divided among beneficiaries, and when is the deadline?

If a person dies before taking all of the annual RMD, whatever remains must still be withdrawn. The responsibility for taking the year-of-death RMD then falls to the beneficiary. It’s not paid to the IRA owner’s estate (unless the estate is the named beneficiary). It is paid, and is taxable, to the beneficiary.

If there are multiple IRA beneficiaries, the IRS doesn’t care who takes the year-of-death RMD; the IRS just wants it to be taken.

MISSED YEAR-OF-DEATH RMDS

If multiple beneficiaries elect to divide the year-of-death RMD equally, they can do so. If one beneficiary chooses a lump-sum payout, that could satisfy the entire year-of-death RMD. This is often the case when a charity is the beneficiary.

The deadline for taking the year-of-death RMD is Dec. 31 of the year of death. If the original IRA owner dies late in the year and had not yet taken his RMD, the year-of-death RMD will often be missed. Such situations have been so prevalent that the IRS created an extension for missed year-of-death RMDs. The proposed SECURE Act regulations waive the penalty if the year-of-death RMD is taken by the beneficiary’s tax filing deadline, including extensions.

2. Which life expectancy table is used by an eligible designated beneficiary to calculate annual RMDs on inherited IRAs?

For deaths after 2019, certain beneficiaries (called “eligible designated beneficiaries” or EDBs) can still stretch RMD payments. EDBs include surviving spouses; minor children of the account owner up to age 21; disabled or chronically ill individuals; and individuals not more than 10 years younger than the IRA owner.

Following the IRA owner’s death, an EDB uses the IRS Single Life Expectancy Table to calculate the initial RMD factor in the year after the year of death. That factor is based on the age of the beneficiary — not the age of the IRA owner — on her birthday in the year following the year of death. For each subsequent year, a non-spouse EDB will subtract one from the previous year’s life expectancy factor. Spouse EDBs use the applicable factor from the table for each subsequent year.

3. Whose life expectancy are annual RMDs based on during years one through nine of the 10-year period?

Under the IRS proposed regulations, beneficiaries subject to the 10-year rule are also required to take annual RMDs in years one to nine of the 10-year period if the retirement account owner died on or after the RBD.

To calculate RMDs within the 10-year period, the beneficiary uses his own single life expectancy — not the account owner’s life expectancy — for the first RMD (due by Dec. 31 of the year following the year of death). That life expectancy is determined under the IRS Single Life Expectancy Table and is based on the beneficiary’s age in the year of the first RMD (the year after the year of death). For each subsequent year, the RMD factor is reduced by one.

These Q&As represent only a small fraction of the inherited IRA issues that we regularly tackle. With ever-changing laws and IRS guidance, it’s crucial for advisors to stay on the leading edge of how inherited IRAs are affected. Incorrect advice can sink a lifetime of retirement savings, not to mention the advisor’s reputation.

[More: Inherited IRA RMD rules 2023: RMD quirks that IRA beneficiaries face in ’23]

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com.