Figuring out the most efficient way to navigate the tax impact of inheriting individual retirement accounts has become more complicated since the Internal Revenue Service issued proposed new rules in February.
The rules for inherited IRAs changed most recently in the SAFE Act of 2019, which introduced a new 10-year payout rule for inherited accounts. The previous rule said those who inherited an IRA, Roth IRA or 401(k) could spread withdrawals over their lifetime.
Many tax professionals interpreted the new 10-year rule to mean those heirs could wait until the 10th year before receiving payments, and that’s what the IRS said in a May 2021 revision to Publication 590-B, a 69-page guide to Distributions IRA. But then in February, the IRS issued new guidance that would require heirs to take annual withdrawals in cases where the original owner died on or after the required start date for taking distributions.
Annual distributions are based on a formula that takes into account the IRA balance and the recipient’s age. The new guidance also applies to 401(k)s, but with those plans, employers often already set even more restrictive payout rules.
Payments from an inherited traditional IRA are taxed like wage income. The new guidance means many Americans who inherit an account will inherit it during their working lives and therefore pay a much larger tax bill, accountants say.
“It’s just terribly complicated,” says Michael Jones, a CPA in Plymouth, Minn., who wrote a book in 2014 about the tax benefits of extending inherited IRA payouts.
Taxpayers can deal with the new law and guidance by calculating the necessary amount each year. Or, they can cash out the first year and pay a tax bill. Taxpayers who fail to take the required distribution are subject to a tax penalty equal to half the amount that should have been withheld.
“Maybe just go ahead and take that holiday in France,” says Mr Jones.
In particular, spouses and certain classes of heirs, including the disabled, can distribute withdrawals during their lifetime. And inherited Roth IRA owners don’t have to receive payments until the end of the 10-year period because Roth IRAs have no annual payment requirements.
Sy Goldberg, an attorney in Melville, New York, has a client whose mother died at age 90 in 2021. The client left two traditional IRAs, one worth $105,000 and the other $35,000, to her four grandchildren.
This meant that there were then eight separate IRAs, with each grandchild having to calculate their own life expectancy and take different distributions in years one through nine. The balance will be taken in the 10th year, as per the proposed rules.
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“Grandma meant well, but the plan backfired,” Mr. Goldberg says. The grandchildren decided it wasn’t worth the hassle, so they took lump sum distributions, he says.
In public online comments on the rules, some taxpayers and industry groups, including the Investment Company Institute and the American Institute of Certified Public Accountants, are urging the IRS to drop the additional annual distribution requirement or temporarily waive the penalties for people who inherited money since 2019 but have not received distributions.
One taxpayer put it succinctly: “Just leave it as plainly written as that is too confusing.”
The IRS says it is reviewing the comments and will respond to them in the final rules. The proposed regulations represent the IRS’s view of the law.
“I read about the change and started panicking about the penalties,” says Margaret Rolo, of Rancho Mirage, Calif., who hadn’t touched the $400,000 IRA she inherited from her mother, who died in 2020.
Ms. Rolo says her financial advisor told her to wait and see how the final IRS rules play out. Taking a distribution in 2021, combined with a high-income year, would mean a big tax bill, Ms. Rolo says.
Kathy Houser of Ann Arbor, Mich., handles tax returns for her family. She said that after her husband, a supply chain analyst, inherited a $50,000 IRA from his father in 2021, they made a financial plan to start taking distributions in the seventh year, when he expects to retire, to minimize taxes.
The new guidance will thwart their plan.
“I was an IT professional before I retired and I can run a spreadsheet, but even that makes my head spin. It’s asking a lot of taxpayers,” he says.
In a recent paper analyzing retirement distributions, Peter Brady and Steven Bass, economists at the Investment Company Institute, found that 1.6 million taxpayers took a total of $9.2 billion in IRA distributions in 2010, and the average distribution was $5,578. Those numbers are likely much higher today as the population has grown and the total value of IRA assets has grown to $13.2 trillion from $5 trillion in 2010.
The IRS could potentially waive penalties for missed 2021 distributions and then require taxpayers to deduct the balance for the remainder of the 10-year period, says David Donnelly, CPA with Carr, Riggs & Ingram in Houston.
The IRS could also force taxpayers to make up missed distributions, or they could revert to previous guidance.
“It will depend on how agitated Congress gets about it,” Mr. Donnelly says.
For 2020 heirs who missed a 2021 distribution, Mr. Jones says they should play it safe and make a make-up distribution, file a Form 5329 to report the shortfall and attach a penalty waiver request that explains because they had reasonable cause for non-distribution.
For 2021 heirs who need to take their first distribution this year, they could wait until the end of the year to see if the IRS or Congress make changes.
Write to Ashlea Ebeling at email@example.com
Fixes & Enhancements
Kathy Houser’s husband works as a supply chain analyst. An earlier version of this article incorrectly said he was a pilot. (Corrected on August 1.)
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