Confusion Reigns Over 10-Year Nonspousal Inherited IRA Rule
Back in February, the IRS (as it seems prone to do) sowed confusion among taxpayers who have inherited IRAs from a nonspouse, as well as, those of us who advise them. The confusion stems from the IRS interpretation of the so-called "10-Year" distribution rule as it laid out in 275 pages of proposed regulations. To understand the issue, it's instructive to know the back story.
Prior to 2020, if you inherited an IRA from someone, spouse or otherwise, you had great flexibility as to when to take distributions from it. While you would be required to take annual required minimum distributions (or RMDs) of some amount, if you so desired, those distributions could be taken out over your entire life expectancy. Quite literally, for someone relatively young, the RMDs could stretch over decades, thus this became known as the "stretch IRA" planning technique.
Needless to say, the ability to "stretch" the related tax deferral was worth a ton! So much so that Congress decided to put a stop to it. In the SECURE Act passed in 2019, while a spousal beneficiary could still take advantage of this rule, nonspouse beneficiaries (with a few exceptions) were generally required to drain the IRA over no more than a 10-year period of time.
This effectively ended the lifetime stretch option for most nonspouse beneficiaries, and significantly reduced tax planning options.
Even so, there still were some planning opportunities available. This is because it was generally believed by most tax advisors and experts that as long as the IRA was completely drained by the 10-year mark, it didn't matter when or how frequently distributions were actually taken. In other words, annual distributions wouldn't be required. You could take a distribution in some years, skip others, or even wait and take it all in year 10, whatever made the most sense for you, giving you maximum planning options.
Even the IRS initially indicated, in non-authoritative guidance given via IRS Publication 590-B, that annual RMDs were not mandatory under the 10-year rule.
All that changed for many with the recently issued proposed regulations, in which the IRS did an about face, catching everyone by surprise. Under these regulations, if you inherit a traditional IRA from someone who had already passed their required beginning date and had begun talking their RMDs, you can no longer wait and take distributions whenever you please. Instead, in years 1 through 9, you must take annual RMDs yourself, with the balance being taken in year 10.
Fortunately, if the deceased had not yet reached their required beginning date for taking RMDs, the beneficiary still has the flexibility to wait and time the distributions as they see fit (again, as long as all of it is eventually taken within the 10-year period).
So, what happens if you already inherited an IRA which is subject to this new rule in a year, say 2000, before this regulation was published? Therein lies some of the confusion. Technically speaking, the beneficiary should have already begun taking RMDs, but of course, didn't know he/she was supposed to do so. That creates a dilemma.
In normal circumstances, when someone fails to take an RMD, the correction is to, as quickly as possible, take a distribution in an amount equal to all RMDs that were not taken but should have been. Further, because such a failure is subject to an onerous 50% failure penalty, a Form 5329 should be filed to report the penalty, and either pay it or request a hardship waiver. Is that what someone that finds themselves in this 10-year rule black hole should do?
Or should they wait and see if the IRS will come forward with some form of relief for affected beneficiaries since these regulations were so late in coming and clearly contradicted guidance previously published? There is a call for the IRS to do just that, but it is anyone's guess as to when or even if that may happen.
There is also a call for the IRS to pull these proposed regulations and go back to the preceding guidance. Many experts believe the IRS has overstepped its interpretive bounds here, claiming that they are not in keeping with the statute that made these changes. Because they are proposed regulations, they can still be changed when the "final" regulations are ultimately issued.
Many advisors and taxpayer advocates are strongly calling for a reversal. If you recently inherited an IRA that would be affected by these rules, it may be wise to delay taking an RMD until final regulations are issued and/or we see if some form of relief is granted.
