The Internal Revenue Service has announced that individuals inheriting Individual Retirement Accounts (IRAs) are typically required to fully withdraw the account within a decade following the original owner’s passing. However, the IRS has recently introduced exceptions to this rule, granting more flexibility to certain account holders.
Under the new guidelines, the penalty for not taking a required minimum distribution in 2023 has been waived for heirs who inherited an IRA in 2020 or later, unless they fall into specific categories. Spouses of the original owners, minor children, and heirs who are chronically ill or disabled are exempt from this requirement.
This penalty relief, which was also provided last year, is particularly relevant for those who inherited retirement accounts where the original owners were already subject to mandatory distributions before their death. By allowing these individuals to defer their required distributions for another year, the IRS aims to alleviate potential burdens.
It is important to note that this penalty waiver applies not only to inherited IRAs but also to other retirement accounts, including inherited 401(K) accounts, acquired from 2020 onwards. Failure to withdraw the minimum required amount from these accounts would typically result in a penalty of up to 25% of the mandated distribution for that particular year.
These changes stem from the SECURE Act of 2019, which established the requirement for beneficiaries of IRAs (excluding spouses and minor children) to fully empty the accounts within a 10-year period after the original owner’s demise. Those inheriting such accounts outside the aforementioned categories were granted a window of 10 years to close the accounts.
Overall, these updated rules serve to provide relief for IRA heirs by offering additional flexibility and extending the timeframe for required minimum distributions.
Confusion over the rules
Despite the IRS’s previous view of the 10-year rule, new Treasury Department regulations now require heirs to make minimum yearly payouts before fully depleting the account. This has caused confusion among taxpayers, as they try to reconcile the IRS rules with the Treasury’s regulations. In response, the IRS has introduced temporary penalty relief. However, it remains uncertain whether these annual distributions will be required when final regulations are issued.
It’s important to note that the IRS taxes money from inherited accounts as ordinary income. With this in mind, taxpayers who are already anticipating a high income for the year may choose to postpone their IRA payout. This can be done under the latest penalty relief granted by the IRS, in order to avoid potentially pushing themselves into a higher tax bracket.
Robert Dietz, the national director of tax research at Bernstein Private Wealth Management, advises that waiting before taking IRA distributions may not always be advantageous. Instead, it may be more sensible to take regular distributions over time rather than waiting until year 10, when more income would be subject to a top marginal rate.
Another factor to consider is the future of income tax rates beyond 2026. The 2017 Tax Cuts and Jobs Act temporarily lowered five out of seven income tax rates, with the top rate declining from 39.6% to 37%. However, unless Congress takes action before the end of 2025, these rates will revert to their higher levels. Other rules for individual taxpayers may also change.
Given these circumstances, some individuals who have inherited IRAs may decide that it’s better to withdraw all the funds within a three-year period instead of waiting. Ultimately, the optimal strategy will depend on each taxpayer’s specific financial situation and long-term goals.