IRS Inheritance Proposal Facing Criticism and Pushback

Last February, the Internal Revenue Service jolted financial planners by introducing a potential rule for a recent law under which heirs must drain accounts within ten years. Under its proposal, the tax agency said that heirs would be required to take minimum distributions in years one through nine. It was an about-face from the IRS’s previous guidance in May 2021 that suggested the tax-deferred accounts simply had to be emptied by year ten. That information had led many wealth advisors to assume that more money could be left in the accounts to grow during an heir’s lifetime. It also prompted some planners to tell clients they could skip taking a payout last year. Now, some heirs are facing potentially hefty tax bills and penalties. Required minimum distributions, or RMDs, are taxed at ordinary rates, currently a top 37% for the highest earners. Under the current law, investors who fail to take a full payout in a given year face a costly penalty equal to 50% of the unwithdrawn amount.

The ten-year rule. The agency’s contested proposal stems from a major law passed in 2019 that changed how tax-deferred retirement accounts are passed to beneficiaries. Under prior law, heirs used to be able to “stretch out” required distributions from IRAs and 401(k)s over their lifetime. That meant they would leave more money in the accounts to compound over time and pay the tax bills later. The SECURE Act of 2019 ended the “stretched” IRAs and 401(k)s by requiring heirs to empty them by the end of the tenth year after the original owner’s death. The law applies to beneficiaries of accounts whose owner died on or after Jan. 1, 2020. Heirs who came into possession of an account earlier were grandfathered. The only exceptions to the 10-year rule were heirs who are a spouse, a minor child, disabled, ill, or not more than ten years younger than the account’s original owner. Suppose a beneficiary inherits an IRA seven years after the original owner died, perhaps because that heir was very young or the account was held in a complicated trust. In that case, they only have three years to drain it. The new law also raised the age at which savers must take RMDs from retirement plans to 72 from 70 ½. While owners of Roth IRAs are not required to take minimum annual payouts, people with Roth 401(k)s are. The 10-year rule also catches heirs of Roth plans.

Say what? Many retirement savers appear unaware of the IRS proposal’s annual payout requirement for inherited plans and assume they could wait until year ten to empty the accounts. The issue was made more confusing when lawmakers temporarily suspended all RMDs in 2020 under a pandemic relief bill known as the CARES Act. It resumed the requirement in 2021. The proposal for annual distributions would be a significant hardship for those who did not take an RMD in 2021, and now it is too late without a 50% penalty. Advocates point out that many beneficiaries who do not have professional tax help are also unaware of the ten-year rule. The IRS had misled IRA custodians and trustees into assuming that the ten-year rule did not require distributions in years one through nine.

‘Friction.’ Policy experts and lawmakers are worried about Americans’ readiness for retirement, especially as people live longer. A recent report says that 55% of Americans are in danger “of not fully covering even estimated essential expenses like housing, health care, and food” after they leave the workforce. The IRS proposal does not help things, according to critics. Many believe that taking money out of RMDs needlessly complicates the distribution process for heirs and their financial advisors, and introduces friction into the retirement savings process, which would raise costs for record-keepers, custodians, advisors, accountants, and attorneys servicing retirement assets. 

Talley’s experienced team of tax professionals provides comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on to the next generation the assets and wealth that you have worked hard to build. We welcome the opportunity to discuss the current options available to you. For more information, contact us today.