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IRS Finally Clarifies Withdrawal Rules for Inherited IRAs

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If you receive an inherited IRA from a deceased loved one, you might be celebrating your good fortune. But that windfall comes with strings attached. Unless that IRA happens to be a Roth IRA, you’ll quickly find yourself in the midst of a confusing set of rules about when you need to start taking money out of that account, and how much you’re required to take, in order to satisfy Uncle Sam.

Rules about inherited IRAs have been up in the air for at least the past five years. But in recent weeks, as explained in this Wall Street Journal article, the Internal Revenue Service has issued new regulations designed to clarify the confusion. The new guidelines appear to have answered some questions while leaving others unaddressed.

Ashlea Ebeling wrote the article. She explains how savers have been “waiting for clarity from the IRS for years,” ever since a 2019 law changed the rules. Let’s take a look to see how much clarity the new rules actually provide. (Please note that a subscription may be required to access the Wall Street Journal article.)

New Rules on Inherited IRAs Clarify Withdrawal Requirements

“People who inherit retirement accounts have 10 years to take out the money,” Ebeling begins her article, “and most of them must take out a minimum amount each year, under rules the Internal Revenue Service finalized [July 18th].”

Prior to 2019, those inheriting IRA accounts could hang onto those funds for many years, making Uncle Sam wait for the deferred tax revenue. But that law changed 5 years ago.

“It used to be that most heirs could stretch out inherited retirement account withdrawals over their lifetimes, meaning decades of smaller payouts and more growth potential,” says the Wall Street Journal. “In 2019, a new retirement law said many people who inherited individual retirement accounts or 401(k)s had to take the money out within 10 years.”

10-Year Withdrawal Requirement Left Unanswered Questions 

While the 2019 rules clarified the 10-year withdrawal requirement for inherited IRAs, there was one big question left unanswered: could heirs keep the funds on deposit for a decade and make the entire withdrawal in year 10?

“The law didn’t specify whether people had to take out money each year, or could wait until the final year to take out all of the funds,” Ebeling writes. Indeed, says the article, investors had petitioned the IRS “to do away with minimum annual withdrawals to take advantage of tax savings and allow their money to grow.”

But the just-issued final rules say no. Withdrawals must come out each year for many heirs, the IRS has declared, because (says the agency) that’s what Congress intended when they mandated the 10-year withdrawal requirement.

Spouses Unaffected by Change to Inherited IRA Rules

Not everyone is equally affected by the new requirements. “The rules affect most heirs, but not spouses,” says the Wall Street Journal. But the change is retroactive. “The new guidance applies to both future inheritors and the many people who inherited accounts since 2020, who have been in limbo waiting for the rules,” the article adds.

As Ebeling explains, this new set of guidelines reflects a financial landscape in continuing flux. “Congress, in an effort to raise revenue and keep the wealthy from shielding money, has been changing laws governing the trillions of dollars in 401(k)s and other retirement accounts,” she writes. “It is also likely to keep doing so.”

The net result will be a more complexity, not less, as “individual investors will have to readjust how they plan for retirement and continue to work through a maze of ever-changing new rules,” the article states.

New Rules on Inherited IRAa: Another Exemption

The Wall Street Journal article lists two sets of heirs to whom the recently-announced withdrawal guidelines do not apply.

“The new rules don’t apply to spouses who inherit an IRA—that is a whole different set of rules,” says Ebeling. “It also doesn’t apply if the person with the IRA died before required distributions kicked in—today, that is anyone under age 73.”

Non-spouses who inherit an IRA under those circumstances have a bit more flexibility. “If someone died and left you an IRA before they had to take withdrawals,” Ebeling writes, “you are allowed to take the money out any time during the 10-year period, even waiting until year 10, according to the final rules.” However, there’s yet another caveat: once you turn 73, those withdrawals have to happen annually starting by April 1st of the following year.

But for most, this exemption is moot. “If the person who died was required to take withdrawals,” Ebeling continues, “the person who inherits the account must take annual payouts starting the year after death. The law mostly affects children and other inheritors, like grandchildren, siblings and friends.”

IRS Ruling “Excuses” Those Who Postponed Withdrawals

Those who have been in limbo and have skipped withdrawals in recent years appear to be getting a pass from the tax man, says the article.

“Because there has been confusion about the new rules, many people didn’t take distributions in the past several years,” Ebeling writes. “The IRS has essentially excused them, saying it won’t penalize people in this situation for failing to take required payouts for the years 2021 through 2024.”

The penalty for missed withdrawals used to be 50 percent of the required withdrawal, but Congress reduced that to 25 percent in a separate retirement law effective in 2022. However, while those who postponed withdrawals might not face a penalty, they won’t be getting an extensi0n from the feds. 

“Some who inherited IRAs in the years 2020 to 2023 and held off on taking withdrawals had hoped the IRS would give them a few extra years to empty the account. But the final rules don’t extend the 10-year period,” according to Georgia-based IRA consultant Denise Appleby.

“You have to start taking annual withdrawals in 2025, with the calculation of how much based on your life expectancy,” Ebeling writes. “If you were worried about having to make a big payout in 2025 because you skipped withdrawals from 2021 through 2024, that won’t be the case.”

Minimum Withdrawals Can Trigger a “Tax Balloon”

“Withdrawals from traditional retirement accounts are taxable,” Ebeling reminds readers. For that reason, “heirs should be careful if they take out only the required distributions each year. Doing so would mean a balloon distribution in the final year and potentially a big tax bill.”

This requires some expert tax advice – not to mention strategic timing of withdrawals over the required 10-year period.

Older Laws Governing Inherited IRAs Remain in Force

Needless to say, with a topic as complex as IRAs and taxes, there is ample room for perplexity. That fact is compounded because the new IRS rules leave a host of older regs in force.

“The final rules don’t end the confusion,” says Ebeling. “Congress layered the new law on top of older IRA rules, so heirs can be left juggling multiple IRAs with different payout rules.” This can mean differing payout requirements governed by different life expectancy rules depending on the source of the account.

If you inherited an IRA or 401(k) account before 2020, you are still subject to the old rules, says the Wall Street Journal, requiring annual withdrawals over your expected lifetime. Also, as mentioned at the top of the article, Roth IRAs are governed by a different set of rules.

“The best type of IRA to inherit is a Roth IRA,” says Ebeling. “You don’t have to take the money out until the 10th year, and withdrawals are generally tax-free.”

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(originally reported at www.wsj.com)

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