The End of the Stretch IRA Strategy
Prior to the December 2019 Secure Act becoming law, many advisors recommended what was called a Stretch IRA Strategy for designated beneficiaries of inherited IRA accounts. In most cases under the strategy a designated beneficiary could take distribution of the account funds over their life expectancy. When the Secure Act went live, the Stretch IRA Strategy was eliminated and re-categorized treatment of those funds to beneficiaries. As a result, a ten year cap was put on the time that money was allowed to grow tax-deferred. That cap became known as the 10 Year Rule. Then, only if the inherited account holder met certain defined exceptions* that allowed them to be classified as an eligible designated beneficiary, could they take distributions over their own full life expectancy.
Under the Stretch IRA distribution Strategy, a beneficiary who, for example, inherited the IRA and had a life expectancy of 50 years, and then died 10 years in, the successor beneficiary could continue the remaining 40 years—which would be a lot of years in this example. The Secure Act said no, even if a beneficiary was taking distributions over their full life expectancy, if they die after 2019, the successor beneficiary now has a maximum period of 10 years. So, as long as the owner or the beneficiary dies after 2019, there was a 10-year maximum period to work with.
New Required Minimum Distribution (RMD) Rules
An account owner who comes of age (currently 73) in the year that they are required to begin taking RMDs must begin drawing them no later than April 1st of the following year. Failure to take RMDs by this required beginning date would incur an IRS excise tax. Regulations also stated that once someone began taking annual RMDs, they cannot be halted.
Under this provision a beneficiary who inherited an account from someone who died on or after the original owner’s required beginning date, must take annual RMDs. Exceptions are made for certain eligible designated beneficiaries, such as the surviving spouse of the original account owner, disabled or chronically ill beneficiaries (deemed so at the original account owner’s death), minor children of the account holder (up to age 21), and those beneficiaries not more than 10 years younger than the account holder. These designated beneficiaries may have the option of a) taking distributions according to the 10-year rule or b) taking them over the course of their own life expectancy. An eligible designated beneficiary can also move the funds to another account in which they are eligible to take distributions over their life expectancy.
It's worth noting that from Tax year 2025 onward, failure to take RMDs results in an excise tax.
Because Roth IRAs have no required beginning date for distributions, beneficiaries must apply the 10 year rule and fully withdraw the funds within 10 years of the original owners death. For the first nine of those years taking distributions is optional but the beneficiary must empty the account no later than the end of the 10th year.
If the beneficiary is a non-designated beneficiary, e.g., a non-person (such as an estate), the distribution period is reduced from 10 years to five.
Temporary Waiver of RMDs for Tax Years 2021 – 2024
Because of confusion about interpreting the IRS’ RMD rules in recent years, excise taxes for RMDs not taken in tax years 2021 – 2024 were waived until rules were clarified and settled for the 2025 tax year. Also, there are no catch-up tax payment rules burdening these waived excise taxes. In all cases, waivers for missed RMDs can only apply to this four year period.
Beginning with 2025, missed RMD payments result in a 25% excise tax penalty, even designated beneficiaries who thought they had up to 10 years to begin taking annual RMDs. But those regulations created an uproar because IRS was effectively telling these individuals that they were required to take annual RMDs. Because many of them didn’t, thinking they didn’t have to, they ended up owing the IRS an excise tax, which until then was 50%. Thus, the waiver period from 2021 – 2024. Excise tax was reduced to 25% effective 2023.
Requirements of Non-spouse Beneficiaries and Other “Eligible Designated Beneficiaries”
At the outset, one has to determine the beneficiary class of the non-spouse beneficiary, whether a regular designated beneficiary, or an eligible designated beneficiary. When a non-spouse beneficiary takes a distribution, whether under a signed form or the terms of a governing plan document (e.g., former employer plan), it is a payout and cannot be rolled over under conditions discussed earlier.
Key Concepts and Action Steps to Discuss With Your Advisor
- · In every case, verify your beneficiary status if it is not clear to you, then proceed with your advisor to handle the inheritance in a way to maximize value.
- · Ensure you are compliant with RMD rules to avoid needless penalties—particularly in this pivotal tax year.
- · The period over which you can take distributions as a beneficiary has already been shortened. Don’t miss the RMD deadline, because if you do the
excise tax is 25%. - · If you’ve missed a deadline and make a timely correction, the excise tax could be reduced to 10%, or in some cases waived, if delay is due to a
reasonable error (e.g., the beneficiary didn’t know of
the inherited account). Your tax professional can file the appropriate form and explain to the IRS that the deadline was missed due to reasonable
error. - · Whenever possible, keep the funds in an account that allows them to remain tax free as long as possible to maximize benefit.
- · Where applicable, review copies of plan documents with your advisor to discern whether there are restrictions or time constraints that could work
against you or require action within a certain time frame.
Not surprisingly, many people find IRS rule changes complex and confusing. The smartest strategy is not to approach handling them alone.