One of the most significant changes made by the SECURE Act limits the distribution period to 10 years for designated beneficiaries. An example provided by the IRS in Pub. 590-B has led to some confusion.
The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) was signed into law on December 20, 2019 as part of
the Further Consolidated Appropriations Act, 2020. One of the more significant changes made by the SECURE Act repealed the provision that allowed designated beneficiaries to take distributions over their life expectancies. Now, designated beneficiary who inherit IRAs after 2019 must distribute these IRAs within 10-years. An example of this new 10-year rule in IRS Pub. 590-B-Distributions from Individual Retirement Accounts (IRAs) for use in preparing 2020 returns (Pub. 590-B) has raised questions about how it works, making it necessary to review some key facts.
A designated beneficiary is a person or trust that meets certain specific requirements and named as beneficiary of an IRA.
If a designated beneficiary inherited an IRA before 2019, her distribution options are as follows:
- If the owner died before the RBD*: The 5-year rule or over her single life expectancy.
- If the owner died on or after the RBD: Over the longer of her life expectancy or the remaining life expectancy of the decedent.
Note: *The required beginning date (RBD), is April 1 that follows the year in which the IRA owner reached age 70 ½ (72 for IRAs inherited after 2019).
Under the 5-year rule, distributions are optional until December 31 of the 5th year that follows the year in which the IRA owner died; at which time the entire balance must be distributed.
The SECURE Act changed the rules for IRAs inherited after 2019 by upgrading the 5-year rule to 10 years effective for IRAs inherited after 2019 and removing the option that allowed designated beneficiaries to take distributions over their life expectancies. Changes were also made for successor beneficiaries, some of which are also highlighted in this article.
Pub 590-B includes an example that suggests that designated beneficiaries would take distributions over their life expectancies, despite being subject to the 10-year rule. Word through the IRA grapevine is that the IRS has since admitted that the example used in the explanation was not intended to convey such a message, and will clear up any confusion in proposed RMD regulations that will be issued soon. In the meantime, the following 5 facts should be helpful.
The Age of IRA Owner at Death is Immaterial for a Designated Beneficiary
Whereas the 5-year rule was an option for a beneficiary that inherited an IRA before 2020 only if the IRA owner died before the RBD, the 10-year rule applies to a designated beneficiary regardless of the age at which the IRA owner dies.
As a result, it is no longer necessary to determine the age of the IRA owner at the time of death for distribution purposes if the IRA owner died after 2019 and the beneficiary is a designated beneficiary
Distributions Are Optional Until the End of Year 10
As explained above, where the 5-year rule applies, distributions are optional until the end of the 5th year that follows the year of the IRA owner’s death. The only change that the SECURE Act made to the 5-year rule was to extend it to 10 years for designated beneficiaries. Therefore, for designated beneficiaries who are subject to the 10-year rule, distributions are optional until December 31 of the 10th year that follows the year in which the IRA owner dies.
Did the IRS Get it Wrong?
Pub. 590-B includes the following example:
“Your father died in 2020. You are the designated beneficiary of your father’s traditional IRA. You are 53 years old in 2021, which is the year following your father’s death. You use Table I and see that your life expectancy in 2021 is 31.4. If the IRA was worth $100,000 at the end of 2020, your required minimum distribution for 2021 would be $3,185 ($100,000 ÷ 31.4).”
This example is incorrect because it states that the “required minimum distribution for 2021 would be $3,185 ($100,000 ÷ 31.4)”, which means that the beneficiary must distribute $3,185 in 2021. If the beneficiary was an eligible designated beneficiary taking distributions over her life expectancy (see Fact Number 4 below), this example would be accurate. But for a designated beneficiary, distributions for an IRA inherited in 2020 would be optional for 2021 and therefore not an RMD. The IRS made this rule clear in more than one instance in the same issue of Pub 590-B, including where they stated the following:
“Don’t use any of the tables if either the 5-year rule or the 10-year rule…applies”.
It is therefore clear that the IRS knows that no calculation is required when the distribution option is the 10-year rule.
The 10-Year Rule Applies to a Successor Beneficiary of a Pre-2020 Beneficiary Taking Distributions over Her Life Expectancy and Dies after 2019
If a designated beneficiary inherited an IRA before 2020 and was taking distributions over her life expectancy, her successor beneficiary would take distributions over what remained of her- the designated beneficiary’s- life expectancy. However, this option to take distributions over what remained of the designated beneficiary’s life expectancy applies only if the designated beneficiary died before 2020. If such a designated beneficiary dies after 2019, the successor beneficiary is subject to the 10-year rule. This 10-year period starts the year that follows the year in which the designated beneficiary dies.
The 10-year Rule Applies to the Successor Beneficiary of an Eligible Designated Beneficiary Taking Distributions over Her Life Expectancy
Eligible designated beneficiary is a new category of beneficiary that was created under the SECURE Act and applies only to IRAs inherited after 2019. These beneficiaries are:
- A: the surviving spouse of the IRA owner
- B. a child of the IRA owner who has not reached the age of majority, as defined under state law. Once the child reaches the age of majority, that child becomes a regular designated beneficiary and has 10 years (after reaching the age of majority) to distribute the inherited IRA
- C. disabled- which generally means meeting the social security administration’s definition of disability
- chronically ill – subject to meeting certain specific requirements, or
- E. an individual not described in any of the previous categories (A to D) who is not more than 10 years younger than the IRA owner.
An eligible designated beneficiary is eligible to take distributions over her life expectancy, and in doing so, her successor beneficiary would then be subject to the 10-year rule. This 10-year period starts the year that follows the year in which the eligible designated beneficiary dies.
An IRA Inherited by a Beneficiary Who is a Minor Would Later be Subject to the 10-Year Rule
If the eligible designated beneficiary is a minor child of the IRA owner, he is eligible to take distributions over his life expectancy. As stated above under Fact Number 5, a minor child of the IRA owner would be an eligible designated beneficiary and his successor beneficiary would be subject to the 10-year rule upon his death. However, this applies only if the minor child dies before reaching the age of majority- as defined under State law.
There is an added layer for a beneficiary who is a minor child of the IRA owner, where the distribution option is switched from the life expectancy option to the 10-year rule when the minor child reaches the age of majority as defined under State law.
Advisors Will Need to Amend Their Beneficiary Checklists
Beneficiaries who fail to take RMDs by the applicable deadline will owe the IRS a 50% excess accumulation penalty of any RMD shortfall. This includes those who are subject to the 10-year rule and fail to fully distribute the account by the end of the 10-year period.
Advisors should update their beneficiary questionnaires to ensure that the answers provided clearly show whether a beneficiary is a designated beneficiary, an eligible designated beneficiary or a successor beneficiary. And, for successor beneficiaries, advisors will also need to know whether the primary beneficiary was eligible to take distributions under the life expectancy option and was doing so.
This article certainly does not address all of the applicable factors. But it is a good place to start. When issued, the proposed RMD regulations should provide answers to some of the questions that are still outstanding.