Inherited IRAs and the 10-Year Rule: Beware of Potential Tax Consequences in the Future

Inherited IRAs and the 10-Year Rule: Beware of Potential Tax Consequences in the Future

If you have inherited an IRA after 2019 from a non-spouse, it is highly likely you are subject to the rule under the SECURE Act (passed in December 2019) forcing beneficiaries to distribute the entire account within 10 years.  There are specific beneficiary exceptions to this rule, with spouses being the largest and most important exception.  If you have inherited an IRA prior to 2020, nothing has changed for you, and you can maintain the status quo without having to concern yourself with any new 10-year deadlines.  For the rest of you, tax planning associated with these accounts subject to a 10-year payout period may be especially important.

One question that has not been directly addressed is whether you might be subject to required minimum distributions (RMDs) from an inherited IRA during the same 10-year period.  In essence, the inquiry is whether or not a beneficiary of such an account needs to make mandatory payments based on their life expectancy for the first 9 years of the 10-year payout period, or whether nothing is required to be distributed for these first 9 years.  Regardless of either approach, the entire remaining balance is now required to be emptied out of the inherited retirement account in year 10.

Congress had an opportunity to address this question when they passed the SECURE Act 2.0 (legislation that built upon the first SECURE Act).  They did not, unfortunately, give us any further clarity.  Instead, we have been relying on the IRS to effectively tell us what we should do.  The IRS initially waived penalties for failing to take RMDs for certain IRAs inherited in 2020 and 2021 (initial RMDs would have been due for 2021 and 2022, respectively, as the 10-year payout period starts the year after death).  Later, the agency waived missed RMD penalties for IRAs inherited in 2022 for the 2023 tax year.  It is important to note here that missing RMDs absent a waiver of penalty would have had significant consequences: with certain exceptions, the maximum current penalty for a missed RMD is 25% of what should have been distributed based on the RMD calculation.  The IRS recently extended the waiver for 2024 RMDs that would have been due on retirement accounts inherited in 2023, seemingly kicking the can down the road and waiting for Congress to eventually act.

But this doesn’t necessarily mean you should continue to simply enjoy the tax deferred growth and ignore the clock as it slowly ticks toward the 10^th year if you have inherited an IRA after 2019 and are subject to the 10-year payout period.  With the exception of an inherited Roth IRA, any distribution taken from this inherited retirement account is subject to ordinary income tax rates.  Assuming the IRS continues to waive penalties associated with “missed” RMDs, and assuming Congress does not decide to address the matter directly with new legislation, if you wait until the 10^th year to distribute the principal to empty the account, the entire balance is subject to ordinary income tax rates and might force you into a higher tax bracket and tax rate being applied to the distributions.

For example, let’s say you have a $500,000 inherited IRA you received in 2020.  The first year of your 10-year payout period started in 2021.  Let’s assume the IRS waives penalties on RMDs due indefinitely.  If you waited until 2030 to take the entire amount out, the entire distribution would be subject to ordinary income tax rates.  Assuming a 5% growth rate on $500,000, compounded annually, you would have $814,447 in the account in that 10^th year.  Nice work.  Let’s also assume for this example that you make $100,000 per year in a salaried position in this 10^th year.  You now have $914,447 in income to report to the IRS all subject to ordinary income tax rates.  The current top tax bracket for a single filer starts at $609,351.  Assuming no other facts in this basic example and this tax bracket applies in 2030, this results in over $300,000 of income being taxed at 37%.  Painful.

But what if you decided to take a distribution of approximately $80,000 per year, every year until the inherited IRA was emptied, regardless of whether the IRS continues to waive penalties going forward or Congress requires RMDs eventually on these accounts?  Assuming your normal salary stayed at around $100,000 for the full 10 years, the $80,000 distribution each year would be subject to a 24% tax bracket as a single filer.  Essentially, you have locked in the marginal tax rate that governs the distributions, and your effective tax rate associated with the inherited IRA distributions is much more reasonable versus having filled up the 24%, 32%, and 35% tax brackets with an inherited IRA distribution, with the remaining portion of this distribution taxed at 37% all in the 10^th year in the previous example given.  Granted you will not have amassed $814,447 in this tax deferred account by that 10^th year if you are taking distributions every year, but you could take that same $80,000 distribution each year and reinvest the amount in a brokerage account and get the same 5% return, accumulating a similar return over time, albeit in a taxable account (but not subject to RMDs or 10-year rules).

The above differing approaches are very simplistic to be sure, and there are many other factors to consider, but I hope they are helpful in illustrating that good tax planning strategies should be deployed when you are lucky enough to receive such an inherited account.  Even though the recent waiver of RMD penalties by the IRS for accounts inherited from 2020-2023 has provided “relief,” it may not be a prudent move to simply enjoy the tax deferred free ride they are giving you.  Certainly, the larger the inherited balance, the greater the potential adverse tax consequences associated with waiting until late in the 10-year period before distributions are taken.  With smaller inherited IRAs, there will be less of an overall tax impact and waiting might be just fine.  But like everything else, the devil is in the details.

As a pillar of our financial planning offering, we regularly assist clients with holistic and comprehensive tax planning.  Although we are not accountants and cannot provide tax advice and counsel, we help clients identify and develop effective tax mitigation strategies and techniques.  Feel free to give us a call.  We would be happy to help.

Jason Foster, Director of Wealth Strategies and Legacy Planning

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