Understanding The 10-Year Rule For Inherited IRAs

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IRAs (Individual Retirement Accounts) rank among the nation’s most popular tax shelters. Folk all along the U.S. economic strata, from the richest to the poorest, take advantage of IRAs.

The popularity of IRAs stems from two factors. First, IRAs allow even modest investors with scant funds to build a future nest egg. And secondly, money invested in IRAs is tax-deferred, which lowers your annual income tax bill.

But all of this said, IRAs are highly regulated and subject to a slew of rules that often seem to be ever-changing.

Case in point, in December 2019, new legislation reframed rules governing non-spouse IRS beneficiaries. Dubbed the SECURE Act, the regulations changed how IRA accounts held by deceased owners can be passed on to non-spouse beneficiaries.

Prior to this new law, individuals were allowed to pass on their IRAs to children, grandchildren, or other non-spouse beneficiaries with no restrictions. These heirs could then stretch the required minimum distributions (RMDs) over their own lifetimes. And in turn, the inherited IRA funds can continue to grow tax-free, potentially for decades.

This practice was seen as a loophole largely benefiting the rich. In response, Congress passed the SECURE Act, which instituted the “10-year clean-out rule.”

How Does The 10-Year Clean-Out Rule For IRAs Work?

The funds from IRAs transferred through inheritance to non-spouse beneficiaries after the 2019 fiscal year must be distributed within 10 years of the original owner’s death.

There are, of course, a few exceptions. Surviving spouses and minor children of the original IRA owner and disabled and chronically ill beneficiaries are not required to adhere to the 10-year clean-out rule.

The clean-out rule is not triggered for minor children until they turn 21. And surviving spouses are not subject to the rule change, allowing them to assume an inherited IRA as their own.

Confusion Over How The Rule Change Impacts Distribution During the 10-Year Horizon

Based on the IRS’s initial presentation of this new rule, many tax professionals assumed beneficiaries had options for distributing the inherited IRA funds. They could wait and take all the money in year 10, take annual payouts, or take payments as needed, provided the account was completely drained within the 10-year time frame.

These assumptions, however, were turned upside down when the IRS proposed updated regulations in March 2022. Under the new rules, distribution requirements would shift depending on whether the IRA owner died before they were required to take minimum distributions.

If the owner dies before the required distributions, the beneficiary can wait the entire 10 years, take annual payments, or take payments as needed.

But conversely, if the IRA owner died after their required minimum distributions kicked in, beneficiaries must continue to take a minimum distribution for years 1 through 9, and take whatever remains in the account by the end of year 10.

Further complicating matters, the minimum distribution amount depends on the beneficiary’s age. Younger beneficiaries would be allowed to take smaller distributions than older beneficiaries.

The rule changes have not yet been finalized, and the proposal has garnered significant pushback. Most tax professionals and retirement consultants feel the 10-year rule should be applied uniformly, regardless of when the IRA owner dies.

Fortunately, the IRS has announced any applicable rule changes will not be enforced until at least the 2024 fiscal year. Thus, no one is at risk of penalties for failing to take a minimum distribution.

Questions About How The 10-Year Clean-Out Rule Could Impact You?

If you inherited an IRA from anyone other than your spouse, you should definitely take note of these regulations. After the 2024 extension, you could be in violation of tax if you don’t adhere to inherited IRA distribution rules.

There are also potential strategies that could help you maximize the benefits of inherited IRA funds beneficiaries — Get in touch NOW for a FREE consultation!

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