Editor’s Note: Steven Jarvis will host “The 2023 Next Level Tax Planning Summit” for advisors on Sept. 27-29 in Las Vegas (virtual option also available).
Required minimum distributions (RMDs) on inherited IRAs have been a moving target for multiple years, ever since the original Secure Act was announced in 2019. The rules have been interpreted again and again. Most recently, in July 2023, the IRS announced a further delay in RMDs being required for non-spousal beneficiaries of IRAs.
Some people may use this as an excuse to hold off on tax planning, but doing nothing is usually a great way to get killed on taxes. First, let’s understand where the latest interpretation of the rules currently puts us. Then we will cover where the planning opportunities arise.
When Secure 1.0 first came out, the most obvious change related to inherited IRAs was the implementation of the 10-year rule. This change dictated that a non-spousal beneficiary of an IRA would be required to distribute the full balance of the IRA within 10 years (this technically means by December 31 of the 10th year following the year of the original accountholder’s death, not 10 years from the date of death).
When the rule was originally announced, the leading interpretation was that the account beneficiary had 10 years to withdraw the funds and that it didn’t matter whether they did that evenly throughout the 10 years, all in Year 10, or in any combination of years and withdrawal amounts, as long as the entire account balance was distributed by the deadline.
However, under Secure Act 2.0 (2022), the IRS clarified that this was an incorrect interpretation. Not only is the beneficiary required to distribute the full balance within 10 years, in many cases they must also take RMDs, the IRS indicated.
When do RMDs apply to inherited IRAs?
Following Secure 2.0, the IRS clarified that whether or not an RMD is necessary depends on the age of the decedent and that the amount of the potential RMD is based on the age of the beneficiary. It’s essential to consider the date of birth of both the original IRA holder and the beneficiary to determine if an RMD is necessary and then to calculate how much should be paid.
“It is also important to note that inherited IRAs cannot be aggregated with other IRAs for the purpose of satisfying the RMD for the year.”
It is also important to note that inherited IRAs cannot be aggregated with other IRAs for the purpose of satisfying the RMD for the year.
For example, let’s say Sue has two IRAs in her name that total $100,000 in assets and collectively have an annual RMD of $4,000. The IRS does not care whether Sue distributes the full $4,000 from one IRA, evenly from both IRAs or from any other combination of the two accounts as long as she withdraws the full $4,000 that year.
However, this logic does not carry if we add an inherited IRA to the mix. The calculated RMD for an inherited IRA must be distributed from that account each year to satisfy the requirement.
The IRS recognized when it updated the interpretation of RMD rules for inherited IRAs that, due to the timing of the ruling, it would not make sense to retroactively require RMDs. Instead, it waived all penalties for missed RMDs on inherited IRAs through 2022. The IRS extended this waiver again, through 2023, when it issued IRS notice 2023-54 in July.
Although this might feel like “relief,” advisors serious about tax planning should still take action now.
Why it pays to be proactive
Tax planning and tax savings come down to understanding where choices can be made under the tax code. With Secure 1.0 and 2.0, the focus has been heavily on “what is required.” This has distracted many taxpayers and financial advisors from asking, “What makes the most sense?”
Any advisor who has considered a Roth option knows that it doesn’t always pay to defer taxes. An inherited IRA is no different. It might ultimately be best to only take the RMD and then distribute the remaining balance in Year 10, but an analysis must be done to make sure the taxpayer isn’t getting killed in taxes by doing nothing.
There is no rule of thumb regarding when distributions should be taken over the 10 years in order to minimize taxes; it has to be client-specific, depending on each situation.
Like the traditional vs. Roth IRA determination, it comes down to understanding a client’s relative tax rate across those 10 years. The goal is to then intentionally fill in distributions during relatively low-income years and to avoid additional distributions in relatively high-income years. The most successful tax advisors know what to look out for and help their clients make a plan.
What to watch for
The first thing to do when a client inherits an IRA is to make sure they fill out the paperwork correctly. “Inheriting an IRA” means they were named as a beneficiary and cashed a check. But they do not have an “inherited IRA” until they ensure that the funds they received were properly administered to create an inherited IRA in their name.
As with rollover IRAs, the flow of funds and recordkeeping must be set up correctly. If the check is made out to the beneficiary and they deposit it in their checking account, they’ll lost the opportunity to create an inherited IRA and they will be taxed on the full amount in that year. Unfortunately, that is what happens all too often because people aren’t paying attention.
The next step is to take the time to really evaluate what the next ten years will look like from a tax perspective. No one has a crystal ball but that doesn’t mean plans can’t be made. This doesn’t require a fancy piece of software or a complicated tool; it can be as simple as writing out the next ten years and looking for major events. Labeling a piece of paper with Years 1 to 10 and writing notes about what is expected to happen in each of those years could save a client thousands of dollars in taxes.
That exercise will help you and your clients identify high-income years where it will make sense to only take the RMD, as well as low-income years where intentionally taking larger distributions will help lower the overall tax bill.
High-income years could result when your client sells property, receives large work-related payouts or severance leading up to retirement, starts collecting Social Security, or begins taking RMDs on other IRAs. Knowing when those years are likely to happen provides a road map for years to avoid taking additional distributions from the inherited IRA.
On the flip side, there is the potential for low-income years, such as the period between retirement and collecting Social Security or drawing income from other retirement accounts. Planning ahead could even mean intentionally changing the timing of discretionary income sources to create otherwise low-income years that can be filled in with distributions from the inherited IRA.
Tax planning never happens in a vacuum
It also pays to remember which tax-planning strategies can be used in concert. Qualified charitable distributions (QCDs) are allowed from inherited IRAs if the beneficiary is over age 70 ½ . QDCs should be included in the 10-year worksheet if a client is charitably inclined and will be over 70 ½ at any point during the 10-year window.
If the beneficiary is younger, donor-advised fund (DAF) contributions could be considered to offset the income recognized from the inherited IRA. The best tax planning is done when a taxpayer has someone on their team who not only understands all the levers that can be pulled but also plans ahead for the right time to make those adjustments.
It is easy to get caught up in the headlines of a particular topic, like the RMD rules on inherited IRAs, but value to clients comes from proactive planning every single time. Don’t be satisfied with simply avoiding penalties.
A client who waits until Year 10 to take the RMD will be compliant but will get killed in taxes from taking the entire distribution in one year. Instead, proactively plan to make a positive impact on your client’s tax outcome. Creating a 10-year tax plan also provides a framework to compare the default scenario with a proactive scenario so you can show your client the potential tax savings.
Steven Jarvis, CPA, MBA, is cofounder of Retirement Tax Services, which offers year-round tax services to financial advisors and their clients. Retirement Tax Services will host “The 2023 Next Level Tax Planning Summit” on Sept. 27-29 in Las Vegas (virtual option also available).