Understanding inherited IRA rules for nonspousal beneficiaries under the SECURE Act

To encourage more Americans to save for retirement, Congress passed the SECURE Act in 2019. The measure significantly altered the way Americans saved for retirement, making it easier for small business owners to enroll employees into 401(k) plans while providing certain tax credits to incentivize employers to create 401(k) or SIMPLE IRA plans with automatic enrollment.

In 2022, a new version of the SECURE Act was put into place to address retirement issues that weren’t covered in the original measure. Some of these changes included catch-up contributions, which increased the amount of money older Americans can contribute to their retirement plans, and implementing the Saver’s Tax Credit to help lower-income Americans save for retirement while eliminating certain penalties for hardship withdrawals. It also made considerable changes to inherited individual retirement accounts — specifically, eliminating the distribution stretch strategy for beneficiaries.

The 10-year distribution rule on inherited IRAs

Before the SECURE Act, nonspousal beneficiaries had the option of stretching the IRA distributions according to their life expectancy. This tactic minimized withdrawals, allowing the money to grow tax-free. However, once the SECURE Act was put into place, the strategy was replaced with the 10-year distribution rule. This new rule requires beneficiaries to deplete the account within 10 years of the owner's death.

But here’s where things get complicated — the distribution rule differs depending on when the account owner died. If the owner died before taking the required minimum distribution, the beneficiaries aren’t required to take annual distributions from the account. This gives the beneficiaries more control, allowing them to choose how to make withdrawals from the account provided the funds are depleted by the end of the 10th year.

However, if the account owner began taking RMDs before their death, the beneficiary must take the RMD annually following the first year of death through the ninth. The amount the beneficiary receives depends on their age, causing younger beneficiaries to receive smaller amounts.

Exceptions to the 10-year rule

There are a few exceptions to the rule for nonspousal beneficiaries. In some cases, beneficiaries can use their life expectancy to calculate the minimum distribution. Nonspousal beneficiaries who are chronically ill or disabled, under the age of 21 or are within 10 years younger of the original account owner do not have to follow the 10-year rule.

Criticisms of the 10-year IRA distribution rule

This new distribution rule has received some backlash. Some experts say there’s too much confusion surrounding the RMDs. To provide clarity and consistency, some financial experts say the 10-year rule should apply regardless of whether the original account owner began taking RMDs. Initially, many thought the 10-year rule would trump the need to take RMDs, but unfortunately, that’s not the case. In February 2022, the IRS announced that RMDs will still be required in years 1 through 9 in conjunction with the 10-year rule if the account owner died on or after their RMD start date. It’s important to note that RMDs are taxed and there’s a penalty for not taking them.

Arguably the biggest drawback of inherited IRAs revolves around the RMD. How much you’ll be required to take depends on your age, your relationship to the account holder and whether the account holder began taking RMDs. If you plan to inherit an IRA, consider meeting with the original account owner, if possible, to work through the details. Any incomplete or vague forms can lead to serious problems once the account owner dies. You may also want to consider meeting with a financial advisor. They can help you navigate these rules and regulations according to your specific financial situation.