Some changes have been made to how family Individual Retirement Accounts (IRAs) will work from now on, through 2025. And if you are in charge of one, you should know about these changes. If you don’t, the Internal Revenue Service (IRS) could fine you a lot, which could put your financial security at risk.
People who got IRAs as gifts can be roughly put into two groups: spouses and people who are not married.
Rules regarding inherited IRAs for non-spouses
Required Minimum Distributions (RMDs) must be made by the account owner’s heirs starting the year after the account owner dies if the account owner hit the age at which RMDs are required. This rule might not apply if the original owner wasn’t old enough to take RMDs, but children should still think about taking these RMDs as soon as possible.
Joel Dickson, global head of advice methods at Vanguard, says, “This is about tax planning over several years to get the most out of an inherited IRA.”
After the Secure Act of 2019, inheriting an IRA no longer came with a tax break that let heirs “stretch” their withdrawals over their lifetime. This is a great time to do this. The “10-year rule” applies to most people who receive an account after 2020 and are not married, have a minor child, are disabled, are chronically ill, or are the beneficiary of certain trusts. If someone gives you an IRA, you have to empty it out completely by the end of the 10th year after the account user dies.
Because the rule wasn’t clear, a lot of people thought that RMDs weren’t needed as long as the account was empty by year 10. The IRS has waived penalties for a few years to make sure the rule is clear and no one is getting unfairly punished, but they will be back in 2025.
“You have a multidimensional matrix of outcomes for different inherited IRAs,” Dickson said. That you know how these rules affect your marketing plan is important.
The rule is clear from 2025 on. If the account holder hit the age at which required minimum distributions (RMDs) were due, their heirs will have to keep making withdrawals every year until the account is empty, which will take 10 years.
An RMD penalty of 25% of the amount you should have taken out will be added if you miss it or don’t take out enough. The good news is that the IRS says the penalty can be lowered to 10% if you fix the mistake within two years.
Consider ‘strategic distributions’
If you have to deal with the 10-year rule, spreading out your withdrawals evenly over 10 years can help you pay less in taxes. This is supported by study from June by Vanguard, which shows that this strategy works well for most heirs. There are other ways to deal with your new tax position, though.
Judson Meinhart, director of financial planning at Modera Wealth Management in Winston-Salem, North Carolina, is a certified financial planner. He tells heirs to think about “strategic distributions” because “it starts by understanding what your current marginal tax rate is and how that could change over the 10-year window.”
For instance, if you plan to make less money some years, like when you’re unemployed or in the early stages of retirement before Social Security starts, it might make sense to take out more money from your IRA during those years.
But you should know that this way of making more money might have some negative effects. For example, it might affect your ability to get financial aid for college, change the terms of your student loans if you’re on an income-driven plan, or make your Medicare premiums go up when you retire.