IRS' Secure Act Guidance on RMDs Has a Surprise Twist

The IRS has released long-awaited proposed regulations on inherited IRAs.

The Secure Act upended the rules governing inherited retirement accounts by limiting the value of the stretch IRA to a 10-year period for most account beneficiaries. Now, the IRS has released long-awaited proposed regulations interpreting the parameters of the law.

While most of the required minimum distribution rules remain the same, the proposed regulations answer some important questions left lingering after the Secure Act became effective. They also contained a surprise twist that sharply limits the ability of most non-spousal beneficiaries to stretch the tax deferral of the IRA post-death.

Clients who have recently inherited accounts should take note of the changes — and stay tuned for final regulations, which could be released later this year.

 Secure Act’s Inherited IRA Changes

Under prior law, non-spouse beneficiaries could take distributions from an inherited retirement account either over a five-year period or using the beneficiary’s life expectancy — to “stretch” the tax deferral benefits over the lifetime of the next generation. The Secure Act limited the value of the stretch for most taxpayers who do not qualify as “eligible designated beneficiaries.”

Post-Secure Act, most non-spouse account beneficiaries will be required to take distributions over a 10-year period. 

Eligible designated beneficiaries who are not required to use the “10-year rule” for distributions (so that the pre-Secure Act rules apply) include surviving spouses, disabled beneficiaries, chronically ill beneficiaries, the account owner’s children who have not reached “the age of majority” and individuals who are not more than 10 years younger than the original account owner.

The rules apply to all defined contribution plans, including IRAs, 401(k)s and 403(b) plans.

Proposed Regs Limit the Value of the 10-Year Stretch

In a surprise move, the regulations require most designated beneficiaries to take annual RMDs within the 10-year distribution period if the original account owner died on or after the required beginning date. In other words, the beneficiary can’t simply wait until year 10 to empty the entire account. Of course, the new rule would mean that clients would generate added tax liability in each year of the 10-year period — rather than waiting to pay the entire tax in year 10.

While the Secure Act is silent with respect to whether annual distributions are required, many commentators have already said that the proposed regulations contradict the statute. The IRS, however, has yet to release guidance for clients who inherited accounts after the Secure Act’s effective date and before the regulations were issued. In other words, they don’t address whether a client may be required to take a retroactive RMD for 2021.

Clients in this position generally have two options. They can take two distributions in 2022 and file a Form 5329 to request a waiver of the steep 50% penalty tax for missed RMDs. The second option is to wait until later in the year, when it’s possible that the IRS will have released clarification or final regulations that modify the proposed regulations.

Clarification of Eligible Designated Beneficiary Status

The proposed regulations also clarify a few points with respect to the new definition of “eligible designated beneficiary.” An eligible designated beneficiary is entitled to continue using the life expectancy distribution method even post-Secure Act. 

Under the proposed regulations, the “age of majority” for eligible designated beneficiaries who are minor children is defined as age 21 (many expected that an age 18 limit would apply). Defined benefit plans that use the definition of “age of majority” under the existing regulations can continue to use that definition (meaning that those plans can treat a child as being under the age of majority if that child has not completed a course of education and is under age 26). 

Spousal beneficiaries will also be required to elect to treat the deceased spouse’s IRA as their own by the later of (1) Dec. 31 of the year following the year of the owner’s death or (2) age 72. 

In addition, the regulations propose a rule that would treat an account owner as having no eligible designated beneficiary if the owner has multiple designated beneficiaries and one of those beneficiaries is not an eligible designated beneficiary. 

When multiple designated beneficiaries are involved, the life expectancy of the oldest beneficiary will be used (under prior regulations, the shortest life expectancy was used). 

Conclusion

The proposed regulations are effective Jan. 1, 2022. However, comments are not due until May 25, 2022 — and it’s widely expected that the IRS will receive many comments that could result in changes. For now, clients who have recently inherited retirement accounts should pay attention to changes that could affect their tax liability going forward.

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