Back in late 2019, the first significant legislation addressing retirement savings since 2006 became law. The Setting Every Community Up for Retirement Enhancement (SECURE) Act has resulted in many changes to retirement and estate planning strategies, yet it also raised some questions. The IRS has been left to fill the gaps, most recently with the February 2022 release of proposed regulations which have left many taxpayers confused and unsure of how to proceed.
The proposed regulations cover numerous topics, yet one of the most noteworthy is an unexpected interpretation of the so-called “10-year rule” for inherited IRAs and other defined contribution plans. If finalized, this interpretation — which contradicts earlier IRS guidance — could lead to larger tax bills for certain beneficiaries. Your KerberRose Trusted Advisors have compiled the following key facts to help you navigate the implications of this legislation.
Birth of the 10-Year Rule
Before the SECURE Act was enacted, beneficiaries of inherited IRAs could “stretch” the required minimum distributions (RMDs) on such accounts over their entire life expectancies. The stretch period could be decades for younger heirs, meaning they could take smaller distributions and defer taxes while the accounts grew.
To accelerate tax collection, the SECURE Act eliminated the rules which allowed stretch IRAs for many heirs. For IRA owners or defined contribution plan participants who die in 2020 or later, the law generally requires the entire balance of the account be distributed within 10 years of death. This rule applies regardless of whether the deceased died before, on or after the required beginning date (RBD) for RMDs. Under the SECURE Act, the RBD is age 72.
The SECURE Act recognizes exceptions for the following types of “eligible designated beneficiaries” (EDBs):
• Surviving spouses,
• Children younger than “the age of majority,”
• Individuals with disabilities,
• Chronically ill individuals, and
• Individuals who are no more than 10 years younger than the account owner.
EDBs may continue to stretch payments over their life expectancies (or, if the deceased died before the RBD, they may elect the 10-year rule treatment). The 10-year rule will apply to the remaining amounts when an EDB dies.
The 10-year rule also applies to trusts, including see-through or conduit trusts which use the age of the oldest beneficiary to stretch RMDs and prevent young or spendthrift beneficiaries from rapidly draining inherited accounts.
Prior to the release of the proposed regulations, the expectation was non-EDBs could wait until the end of the 10-year period and take the entire account as a lump-sum distribution, rather than taking annual taxable RMDs. This distribution approach generally would be preferable, especially if an heir is working during these 10 years and in a higher tax bracket. Such heirs could end up on the hook for greater taxes than anticipated if they must take annual RMDs.
The IRS has now muddied the waters with conflicting guidance. In March 2021, it published an updated Publication 590-B, “Distributions from Individual Retirement Arrangements (IRAs),” which suggested annual RMDs would indeed be required for years one through nine post-death. However, just a few months later, it again revised the publication to specify “the beneficiary is allowed, yet not required, to take distributions prior to” the 10-year deadline.
This position didn’t last long. The proposed regulations issued in February call for annual RMDs in certain circumstances.
Proposed Regulations Regarding the 10-Year Rule
According to the proposed regulations, as of January 1, 2022, non-EDBs who inherit an IRA or defined contribution plan before the deceased’s RBD satisfy the 10-year rule simply by taking the entire sum before the end of the calendar year, which includes the 10th anniversary of the death. The regulations take a different tack when the deceased passed on or after the RBD.
As such, non-EDBs must take annual RMDs (based on their life expectancies) in years one through nine, receiving the remaining balance in year 10. The annual RMD rule gives beneficiaries less flexibility and could push them into higher tax brackets during those years. (Note: Roth IRAs don’t have RMDs, so beneficiaries need only empty the accounts by the end of 10 years.)
Aside from those tax implications, this stance creates a conundrum for non-EDBs who inherited an IRA or defined contribution plan in 2020. Under the proposed regulations, they should have taken an annual RMD for 2021, seemingly subjecting them to a penalty for failure to do so, equal to 50% of the RMD they were required to take. However, the proposed regulations didn’t come out until February of 2022.
What about non-EDBs who are minors when they inherit the account yet reach the “age of majority” during the 10-year post-death period? Those beneficiaries can use the stretch rule while minors, yet the annual RMD will apply after the age of majority (assuming the deceased died on or after the RBD).
If the IRS’s most recent interpretation of the 10-year rule sticks, non-EDBs will need to engage in tax planning much sooner than they otherwise would. For example, it could be wise to take more than the annual RMD amount to more evenly spread out the tax burden over the 10 years. They also might want to adjust annual distribution amounts based on factors such as other income or deductions for a particular tax year.
Clarifications of the Exceptions
The proposed regulations clarify some of the terms relevant to determining whether an heir is an EDB. For example, they define the “age of majority” as age 21 — regardless of how the term is defined under the applicable state law.
The definition of “disability” turns on the beneficiary’s age. If under age 18 at the time of the deceased’s death, the beneficiary must have a medically determinable physical or mental impairment which 1) results in marked and severe functional limitations, and 2) can be expected to result in death or be of long-continued and indefinite duration. Beneficiaries age 18 or older are evaluated under a provision of the tax code which considers whether the individual is “unable to engage in substantial gainful activity.”
Wait and see?
The Senate’s Health, Education, Labor and Pensions (HELP) Committee recently released a legislative draft ingeniously titled “Retirement Improvement and Savings Enhancement to Supplement Healthy Investments for the Nest Egg Act” (RISE and SHINE Act). This is the Senate’s version of the U.S. House’s Secure Act 2.0 passed in March. The RISE and SHINE Act aims to enhance retirement savings and improve access to employer-sponsored accounts. If the bill passes in the Senate, it’ll have to be reconciled with the House version before heading to President Biden’s desk. Stay tuned.
The U.S. Treasury Department is accepting comments on the proposed regulations through May 25, 2022, and will hold a public hearing on June 15, 2022. Non-EDBs who missed 2021 RMDs may want to delay action to see if more definitive guidance comes out before year-end, including, ideally, relief for those who relied on the version of Publication 590-B which indicated RMDs weren’t necessary. As always, though, contact us to determine the best course for you in light of new developments.
If you have any additional questions about the SECURE Act and how it could benefit you or your beneficiaries, contact your KerberRose Trusted Advisors today!