What's going on with RMDs for inherited accounts: just because you might be able to wait, doesn't mean you should

An area of financial planning that is especially complicated is what happens when you inherit someone’s retirement assets, meaning their IRAs or 401ks.

If you inherit the account from your spouse, it’s pretty straightforward: you can treat the money as your own retirement savings by combining it with your accounts, and aside from a few specific circumstances, that’s all that needs to happen. But for non-spouse beneficiaries - children, siblings, friends, really anyone else besides the person you’re married to - there are some significant decisions to be made.

First, some background: for account owners who died before 1/1/2020, their non-spouse beneficiaries had the ability to “stretch” their inheritance over their lifetimes. Since the money in question hasn’t been taxed yet, any money that comes out of them will be taxable to the person receiving it: either the original owner, during their lifetimes, or their beneficiaries after the owner’s death. Until a few years ago, those beneficiaries would only be required to distribute a relatively small amount each year, so the tax impact to them was pretty manageable. And of course, they could always take out more if needed.

Enter the SECURE Act. This legislation, passed in 2019, made some big changes to retirement rules, and one of the biggest was the “death of the stretch”: for account owners who died in 2020 or later, their non-spouse beneficiaries would now have only 10 years to distribute - and pay tax - on the entire account balance! This was a major change in how account owners and beneficiaries had to plan for this transfer of wealth. Might it be more tax-efficient for the account owner to distribute more than required during their lifetimes, with the aim of reducing the balance and paying the tax themselves, if their income is lower than their beneficiaries’ was expected to be?

And then, in March 2022, a new wrinkle: the IRS disagreed with the interpretation - widely held across the advisory world - that the law allowed beneficiaries the full 10 year time span to distribute the money on their own schedule. As long as the account was empty by year 10 after death, the rule was satisfied - or so we thought. The IRS, however, said no! If the account owner had already been required to begin their distributions, that at least a minimum distribution would still be required in years 1-9. This was very upsetting and also kind of cryptic! It meant that for people over 70 who passed away in 2020 or later, their heirs had likely missed at least one year of distributions under the apparently wrong assumption that the distribution wouldn’t be required. So what would happen? Would those heirs be subject to a penalty?

Late in 2022, the IRS issued guidance - or they kind of punted the issue. Their proposed - but not definitive -interpretation remains that the distribution would be required, penalties were waived for 2021 and 2022, and issue a final declaration of the rules sometime this year.

So where does that leave you, if you’re one of the post-2020 non-spouse beneficiaries of someone who was already taking their required distributions? Here’s a nifty flowchart to help you figure out where you stand:

Note that officially, at this moment, you’re not subject to the requirement to distribute anything. But! I think the move is to assume that a minimum distribution will be required and prepare to do that at some point by the end of this year. You can do this calculation: look up the age you’ll reach this year on the IRS Single Life Expectancy Table, and divide the balance in the account on 12/31/2022 by the Life Expectancy Factor you find. That’s what you would be required to withdraw. Your custodian or advisor can also figure this for you.

Now, that’s what you’re likely to be required to do. Plus have the entire account emptied by Year 10. It’s good to know that, because avoiding penalties and unpleasant surprises is always good. From a financial planning standpoint though, we can go further and think about what’s the best thing for you to do, which will involve coordinating your household income, the size of the account, your current needs, and anything that might be changing before you reach the 10th year. It’s likely that only taking minimum amounts, or taking nothing if you’re not required to, will lead to a subpar outcome - which I’m defining as less money in your pocket when all is said and done - if a large distribution must then be taken all at once, and possibly taxed more heavily.

It’s especially important to use any lower-income years during this time - maybe someone is taking extended time off work to pursue another degree, or be home with young children - to take distributions when your tax bracket is lower than usual!

As you can see, there’s a lot of nuance here, layered on top of one of the most emotionally fraught areas of personal finance. This is money you’ve inherited from a loved one, and I’ve found that there’s extra incentive to be a good steward and not make a mistake. Just like with everything else, the right answer for you might require a little extra consideration, and even a tradeoff like foregoing additional tax deferral to achieve a better overall result.

Here’s where some of you might be asking: “but I inherited a Roth, not a pretax account! What do I do?” It’s actually relatively simple compared to the pre-tax inheritance: you’re subject to the same rules, including the 10-year distribution and possible RMDs, but since the distributions are generally tax-free, it’s a much more straightforward decision to leave as much as you can until the very end of the 10th year, to maximize that sweet sweet tax-free (not tax-deferred) growth

Others of you might be asking: but the person I inherited this money from died before 2020! What do I do?” You’re still subject to the “old” rules, illustrated here