By Jeff Aga, QKA, QPA, CPC, TGPC, CISP, CHSP
How have the rules affecting beneficiaries changed?
Beginning with account owner deaths in 2020 and later, the Setting Every Community Up for Retirement (SECURE) Act of 2019 made significant changes to the rules on how qualified plan beneficiaries distribute their inherited assets. One significant provision prevents most nonspouse beneficiaries from “stretching” out distributions and taxation over their life expectancy. Before the SECURE Act, nonspouse beneficiaries could take distributions based on their own life expectancy by taking annual required minimum distributions (RMDs). For example, a 45-year-old beneficiary has a life expectancy of 41.0. Previously, the beneficiary could have stretched out the distributions and taxation for 41 years. Now, most nonspouse beneficiaries will be required to deplete the inherited account by December 31 of the year containing the 10th anniversary of the account owner’s death, commonly referred to as the 10-year rule.
Which beneficiaries are subject to the 10-year rule?
The SECURE Act identifies three groups of beneficiaries: eligible designated beneficiaries, noneligible designated beneficiaries, and nonperson beneficiaries.
Eligible designated beneficiaries include
the account owner’s spouse,
disabled or chronically ill individuals,
minor children of the deceased account owner, and
individuals who not more than 10 years younger than the account owner.
A noneligible designated beneficiary is any individual who qualifies as a designated beneficiary but does not fall into one of the eligible designated beneficiary categories noted above. While noneligible designated beneficiaries are subject to the 10-year rule, eligible designated beneficiaries may still elect to take distributions over their full life expectancy.
The third group of beneficiaries consists of nonperson beneficiaries (i.e., entities, such as trusts, estates, or charities). Nonperson beneficiaries of account owners who died before their required beginning date (RBD), which is the deadline to begin RMDs, remain subject to the 5-year rule and—with the exception of certain see-through trusts—must distribute the inherited assets within five years.
Must beneficiaries take RMDs under the 10-year rule?
Under the 10-year rule, the beneficiary of an account owner who died before the RBD can take distributions at any time and in any amount as long as the inherited assets are depleted by December 31 of the year containing the 10th anniversary of the account owner’s death. Because the account owner had not started taking RMDs, the beneficiary is not required to take annual distributions. Many thought that this rule also applied to beneficiaries of account owners who died on or after the RBD, which led to some confusion about the changes under the SECURE Act. The IRS released proposed RMD regulations in 2022, clarifying some of these rules.
Once an account owner starts taking RMDs, the RMDs must continue annually until the account is depleted. If the account is not totally distributed by the account owner before death, then the beneficiaries must continue taking RMDs annually. This is sometimes referred to as the “at least as rapidly rule”. The proposed RMD regulations clarify that designated beneficiaries of account owners that die on or after the RBD must take life expectancy payments for the first nine years, and a total distribution by December 31 of the year containing the 10th anniversary of the account owner’s death.
What happens if the beneficiary hasn’t taken RMDs under the “at least as rapidly rule”?
Normally, if a beneficiary fails to take an RMD, she will be subject to a penalty tax equal to 25 percent of the minimum amount that was not timely distributed. If the failure is corrected in a timely manner, the penalty tax is further reduced from 25 percent to 10 percent.
NOTE: Before 2023, the excess accumulation penalty tax was 50 percent of the RMD amount not taken.
Because of the confusion and misunderstanding of how the 10-year rule worked, the IRS released guidance indicating that it will not enforce the excess accumulation penalty tax for certain designated beneficiaries who did not take their life expectancy payments. This specified relief is limited to distributions required to be made in 2021, 2022, or 2023 under the 10-year rule for a designated beneficiary if 1) the account owner died on or after the RBD in 2020, 2021, or 2022 and 2) the designated beneficiary is not taking payments over their full life expectancy. Going forward, beneficiaries of account owners who died on or after their RBD should be aware that annual payments for the first nine years are required when using the 10-year rule.
Are there any benefits to the 10-year rule?
The 10-year rule allows beneficiaries flexibility when tax planning for their inherited retirement account distributions. For example, the beneficiary of an account owner who died before the RBD could let the inherited account grow for 10 years and then take one large distribution in the tenth year. This strategy allows the inherited assets to grow tax deferred for 10 years before being distributed. If the inherited account is a Traditional IRA, tax planning for distributions within the 10-year period may be advisable in order to optimize the tax impact on the beneficiary. Beneficiaries of Roth IRA owners can also use this strategy to accumulate more tax- and penalty-free assets. Because the options for taking distributions under the 10-year rule are endless, beneficiaries should discuss what would work best for them with their tax professional.
Are there any special scenarios to know about the 10-year rule?
Eligible designated beneficiaries who are minor children of the deceased account owner can start taking life expectancy payments in the year following the year of death. Once the child reaches the age of 21, she will become subject to the 10-year rule and must distribute the remaining assets within the next 10 years. For example, Tony is a 40-year-old single dad who has named his 10-year-old daughter, Samantha, as the sole beneficiary of his Traditional IRA. Sadly, Tony dies in a car accident, leaving Samantha to inherit his Traditional IRA. Under the life expectancy payment option, Samantha must generally begin taking annual distributions in the year following the year of death and continue until age 21 when she reaches the age of majority. Once Samantha turns 21, the 10-year rule takes effect and she will need to deplete the inherited IRA within the next 10 years, or by December 31 of the year in which she turns 31. Alternatively, the 10-year option could have been chosen, with no annual distributions required. But if this was chosen, complete liquidation of the account would have been required by December 31 of the year containing the 10th anniversary of Tony’s death.
