SECURE Act Has Changed the Inherited IRA Rules

When Congress proposes a tax law that affects your retirement plan, should you take steps in anticipation of the change? Sometimes this can work against you. For example, thinking Congress would raise income taxes last year, some taxpayers sold stocks, hoping to pay taxes on their gains at the then current low rates. However, Congress did not raise taxes, and the stock market has since come off historical highs, generating losses in 2022. Trying to save on taxes, these individuals ended up paying taxes a year earlier on stocks valued at market highs. Their strategy failed.

As a general rule, trying to anticipate tax law changes is akin to market-timing your investments: It’s often not a good idea. What if, instead, your concern isn’t a proposed tax law from Congress, but a proposed regulation from the Treasury/IRS? This is where it gets trickier. Proposed tax regulations are meant to interpret already existing law. In theory, regulations just clarify what current law already says.

This is the challenge we are facing presently with proposed regulations to the SECURE Act, the sweeping retirement law passed in the waning days of 2019. Basically, Congress passed the law, but ever since then the IRS has been interpreting how to implement it. These new regulations, a lengthy 275 pages, are the IRS’s way of issuing guidance on how the SECURE Act should operate. They are complex and can dramatically affect how you design your retirement and estate plan for years to come.

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Here’s the challenge: While much of the body of the recently proposed rules is helpful and clears up confusing issues surrounding the SECURE Act that have lingered for more than two years, some of the proposals contain unwelcome surprises.

Inheriting an IRA

One of the big topics covered in the proposals released in February is the taxation of inherited IRAs, 401(k)s and other qualified accounts (for simplicity, let’s just call them “inherited IRAs”). A fundamental question detailed in the regulations is how soon does the beneficiary of an inherited IRA have to draw down and pay income tax on the inherited funds? There are three basic possibilities: within five years, 10 years or stretched out over the beneficiary’s life expectancy.

The SECURE Act made major changes by requiring that most beneficiaries must draw down their inherited IRA within 10 years after the IRA creator’s death. No more “stretching out” the payments over the beneficiary’s life expectancy. An exception is carved out for a comparatively smaller group of beneficiaries, such as spouses and minor children. Adult children, grandchildren and most other designated beneficiaries are now stuck with the 10-year rule – which means more taxes payable sooner.

The IRS has been tasked with explaining these rules in practice, and their explanation is different from what most of us understood previously. In some cases, their new regulations make it easier to manage inherited IRAs. For example, the special rule allowing drawdowns to be spread out over the life expectancy of a minor beneficiary raises the question of who qualifies as a “minor” – a term that varies by state. The regulations make this issue easy to handle by simply defining a minor as someone who is under age 21.

In other situations, however, the regulations impose unexpected requirements and significantly complicate the administration of inherited IRAs.

Can Payments Be Spread Out or Taken in a Lump Sum?

Following the passage of the SECURE Act, the general consensus in the planning community has been that with beneficiaries subject to the so-called 10-year rule, the law requires the funds to be exhausted within 10 years of the year following the participant’s death. So, an adult child who is the beneficiary of a parent’s IRA could wait 10 years after inheriting and then withdraw – and pay taxes on – the funds in a lump sum. This would allow for a decade’s worth of tax deferral and make the process comparatively simple to handle – just empty the account by the end of 10 years.

Now the proposed regulations, however, require that with many of these accounts, the beneficiary must draw down the funds annually. To continue the example above, if the IRA owner is age 74 at death, the adult child beneficiary must first take the balance of his parent’s required minimum distribution by year’s end, then take annual distributions based on the child’s life expectancy for the next nine years, then withdraw 100% of the remaining account by the end of year 10.

This example only describes one aspect of the process. In other situations, beneficiaries may need to account for both their own life expectancy and the decedent’s life expectancy (sometimes called the “ghost life expectancy”). Commentators complain this strained system may require taxpayers in their 90s to keep track of theoretical life expectancies, years after the death of the IRA’s creator.

Inherited IRAs are only one portion of the IRS’s proposed regulations but clearly one of the most controversial. Analysts have used terms like “mess” and “nightmare” to describe some of the provisions. The proposed regulations are currently in the open period for comments, and it is apparent the IRS will get an earful from many in the planning community.

Too Early to Worry? Not Really!

While this addresses the concerns of tax professionals, the question for taxpayers is: “These are proposed regulations – why should I care?”

You should care because this is more than mere political positioning.

• First, regulations are intended to be interpretations of existing law, so there often is no grace period to change your planning ahead of time.
• Second, if such a large percentage of professional planners (including this author) have been caught off-guard by these proposed regulations, you must wonder if your carefully crafted retirement and estate plan is still valid? Maybe you need to change your plan because of these regulations.
• Finally, while there certainly will be fireworks over these rules during the proposal period, in the end they are not subject to an up-or-down vote by Congress . Assuming the regulations are otherwise lawful, the Treasury Department ultimately has the final say on whether these rules will be promulgated.

This means that as early as this fall, we may see these regulations made final. For your situation this may only require being aware, but it also might suggest holding off on a planned strategy until the status of regulations is clarified.

There will be more written on these rules as the competing positions begin to align this spring. The rules are still pending and not officially effective yet, but good planning calls for paying attention.

This is not a politician stumping for votes with a proposed law that’ll never see the light of the day. This is the IRS telling us how they’re planning to tax us. It’s time to listen up.