How Does the IRS Rule on Inherited IRAs Work?

Prior to December 2019, when the SECURE Act became law, inherited IRAs were powerful means of passing along wealth. However, Congress saw this as a loophole and ended it with the 10-year clean-out rule. IRA rules are more complicated now, according to the article from Kiplinger, “IRS 10-Year Rule for Inherited IRAs: Kiplinger Tax Letter.”

There are exceptions to the clean-out rule for beneficiaries who are surviving spouses or minor children of the account owner or beneficiaries who are chronically ill, disabled, or not more than 10 years younger than the deceased IRA owner. For minor children, the exception applies until they reach the age of 21. Then they must empty the account within 10 years.

Unlike other beneficiaries, a surviving spouse may take an inherited IRA as their own. The old rules also apply to people who inherited IRAs before 2020. They can continue to take advantage of the IRA stretch strategy.

For everyone else, the 10-year rule has led to much confusion. Do withdrawals have to be equal amounts every year for 10 years, or can different amounts be taken out at different times during the 10 years? The IRS' interpretation originally led many professionals to think annual payments were not required, and an heir had the option to wait 10 years, then take all the money out in one lump sum.

Further confusion was created in March 2022 when the IRS issued proposed rules based on whether or not the original IRA owner died before or after their first beginning date for taking Required Minimum Distributions (RMDs). If the account owner died before taking their first RMD, their beneficiaries need not take annual distributions but could wait until the last year or skip years as long as the IRA was depleted in 10 years. Estate planning attorneys and retirement professionals were fine with this provision.

What came next surprised us. If the IRA owner died after their start date, annual RMDs must be paid to the beneficiary in years one through nine, with the account depleted in year 10. The beneficiary would calculate annual RMDs based on their own life expectancy. The younger the beneficiary, the smaller the RMD.

The latest IRS proposal on the 10-year clean-out rule still needs to be finalized. Practitioners want the 10-year rule to apply consistently, whether or not the IRA owner dies before or after the RMD beginning date.

There is some relief. In October 2022, the IRS said beneficiaries of IRAs inherited after 2019, for which the decedent owner was already subject to RMDs, won’t be penalized for taking distributions in 2021 or 2022. The IRS has just extended that relief for such beneficiaries to 2023.

Confused about your own inherited IRA situation? Speak with an experienced estate planning attorney and your financial advisor to ensure that you manage your IRA beneficiaries or your inherited IRA, if you were a beneficiary, per the latest IRS rules.

Reference: Kiplinger (July 30, 2023) “IRS 10-Year Rule for Inherited IRAs: Kiplinger Tax Letter”