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IRS Issues Guidance for Inherited IRAs

By: Atty. Curt Ferguson

Key Takeaways:

  • The SECURE Act and SECURE Act 2.0 changed the rules for inheriting IRAs. Inheriting an IRA used to allow beneficiaries to stretch out withdrawals over many years, minimizing taxes. Now, most beneficiaries must withdraw all the money within 10 years.
  • There’s no penalty for not withdrawing money from inherited IRAs in inherited trusts in 2024. The IRS has extended a temporary rule that allows beneficiaries to wait until the end of the 10-year period to withdraw funds, especially from Roth IRAs where the growth is tax-free.
  • For traditional IRAs inherited in trust, you might still want to take withdrawals before the end of the 10 years. Even though there’s no penalty in 2024, withdrawing smaller amounts each year can help you stay in a lower tax bracket.

The SECURE Act in 2019, and then then what has been called SECURE Act 2.0, made dramatic changes in how retirement accounts are treated when they pass on death to beneficiaries. For many years before 2020 the exciting goal for a beneficiary of a tax-deferred IRA was to “stretch out” the withdrawals from the account for as long as possible. This meant drawing a little out of the account each year and only paying income tax on the small withdrawal, while most of the account continued to grow tax-deferred. There were very severe penalties if you did not draw out enough. But the required withdrawals were small.

For example, if a 50 year old person inherited a tax-deferred IRA, she could keep the account in its tax deferred status for over 30 years. She was required to withdraw only about 1/33 of the account the first year (so 97% of the money stayed in the IRA, growing tax-deferred) then the next year she withdraws 1/32, and so forth, that fraction gradually increasing until at age 82 she withdraws ½, and at age 83 withdraws the final balance in the account. And if you inherited a Roth IRA the rules for withdrawals were the same (1/33 the first year, 1/32 the second, and so forth) but all of the money not yet withdrawn during those 33 years was growing completely tax free.  

For almost all non-spouse beneficiaries of IRAs (traditional and Roth) the SECURE Act changed the stretch-out to a maximum of 10 years. This applies to anyone who inherits an IRA from someone who died in 2020 and thereafter.

One point in the SECURE Act was unclear: could one simply wait until the 10th year and withdraw all the money, or did you have to still withdraw at least something during years one through nine? The penalties are still severe if you don’t withdraw enough.

Strategically, if you inherited a Roth IRA you would want to leave all the money in the account, growing tax free, until you simply had to withdraw it. Could that be in the tenth year? In a traditional, taxable IRA, you might not want to wait until the very end because of marginal tax brackets: withdrawing and paying income taxes on perhaps 1/10th of the account each year would keep your marginal tax rate on that money low, whereas waiting until the very last year and withdrawing it all would put that large sum of income in a high tax bracket.

When SECURE Act was implemented (2020) you will recall that the world went bonkers over COVID19. All sorts of laws and rules changed, many on a temporary basis. One of those said “no one, whether it is an inherited IRA or your own IRA, has to withdraw any money during 2020.” Similar laws and rules carried into 2021 and 2022. But then we were back to the big question: if you inherited an IRA and have ten years to withdraw it, do you have to withdraw anything during the first nine years. Very late in 2023, the IRS announced that you did not have to withdraw anything in 2023. But no guidance was given beyond that.

So what will the situation be in 2024? On April 16, the IRS released Notice 2024-35.  This notice extended—but for one year only—the decision by the IRS that no penalties will be assessed if you do not withdraw enough from your inherited IRA. So in essence, if you want to keep deferring (especially on those Roth accounts!) withdrawals closer to the end of the ten year period, you are safe to do so. Don’t forget, on the taxable IRAs, however: you might want to still withdraw some of the money and pay taxes on a smaller amount each year, because if you don’t you are pushing a larger and larger withdrawal toward the end of your 10 year period.

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