The Internal Revenue Service (IRS) recently offered new guidance to adults who inherited an Individual Retirement Account (IRA) from someone other than a spouse. Here’s what you need to know to avoid a stiff penalty.
First, a bit of history.
Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which took effect in 2020, adult children and other non-spouse heirs are required to deplete inherited IRAs and other tax-deferred accounts within 10 years of the death of the original owner.
The law didn’t change the rules for surviving spouses, who can roll the money into their own IRAs or take withdrawals over their life expectancy. Previously, non-spouse heirs could take withdrawals over their life expectancy, which reduced the size of annual withdrawals—and the tax bill. That rule still applies to IRAs inherited before 2020.
In the months after the SECURE Act took effect, many financial professionals assumed the new rules meant non-spouse heirs could wait until year 10 to deplete their inherited IRAs, which would provide them a decade of tax-deferred growth. But earlier this year, the IRS issued guidance indicating that if the original owner had started taking Required Minimum Distribution (RMD), non-spouse heirs must take annual withdrawals based on their life expectancy and deplete the balance of the account in year 10.
If the original owner died before taking RMDs, however, the heirs can wait until year 10 to deplete the account. The guidance created considerable confusion for adult children and others who inherited an IRA in 2020 and thought they had 10 years to deplete the account. To address this issue, the IRS said in October that it won’t enforce penalties for non-spouse heirs who fail to take an annual withdrawal from an IRA inherited in 2020 or 2021. (The penalty for not taking an RMD is 50 percent of the amount you should have taken.)
Basically, if you fall into that category you can wait until 2023 to take an annual withdrawal. But since you still must deplete the account within 10 years, you may want to start taking them anyway. Unless the IRA you inherited was substantial, the RMD probably won’t be very large. For example, a 50-year-old who inherited an IRA worth $200,000 would be required to withdraw $5,848—about 3 percent of the total—in the first year.
