You Have 10 Years to Empty Your Beneficiary IRAs If You Aren’t an EDB

You Have 10 Years to Empty Your Beneficiary IRAs If You Aren’t an EDB

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If you own or are the beneficiary of a retirement account or IRA, you’re probably familiar with the term, “required minimum distribution,” or “RMD.” Simply stated, this is the IRS rule that requires you to take minimum distributions from your retirement and IRA accounts each year beginning on a specified date. The amount of each annual distribution is calculated using the value of the accounts on December 31st of the prior year and an age factor from an IRS life expectancy table.

The RMD regime as it applies to IRAs is often referred to as the “stretch IRA” since it allows designated, or named, IRA beneficiaries to take, or stretch, distributions over their life expectancy. The stretch IRA was eliminated on January 1st for many individuals with the enactment of the SECURE Act.

If you are the beneficiary of a retirement or IRA account that you inherited after 2019, you need to familiarize yourself with the new rules in order to determine the applicable time frame for taking distributions from your account. Noncompliance can result in IRS assessment of an onerous penalty and interest in addition to income tax.

New 10-Year Payout Rule

Under the SECURE Act, most retirement and IRA account beneficiaries who inherit retirement and IRA accounts beginning in 2020 are subject to a new 10-year payout rule. The effective date for this rule is generally for deaths after December 31, 2019. Beneficiaries who are affected by this rule are no longer required to take RMDs from these accounts.

The 10-year payout rule requires retirement and IRA account beneficiaries to empty their accounts by the end of the tenth year after the employee or IRA owner’s death. The rule applies to defined contribution plans, including 401(k), 403(b) and 457(b) plans and traditional and Roth IRAs. It doesn’t apply to defined benefit plans.

Eligible Designated Beneficiaries Exempt from 10-Year Payout Rule

The SECURE Act created three new classes of beneficiaries. The three classes are used to determine the length of time over which each class must take distributions from their retirement and IRA accounts.

“Eligible designated beneficiaries,” or “EDBs,” are exempt from the 10-year rule. The stretch IRA still applies to these individuals since they take distributions using the RMD rules. EDB status is determined at the date of the owner’s, or plan participant’s, death and cannot be changed.

There are five classes of eligible designated beneficiaries, or “EDBs,” as follows:

  1. Surviving spouses
  2. Minor children up to the age of majority, excluding grandchildren
  3. Disabled individuals who qualify under strict IRS rules
  4. Chronically ill individuals
  5. Individuals not more than ten years younger than the IRA owner

In addition to the foregoing five classes, any designated beneficiary who inherited their retirement account or IRA before 2020 also qualifies as an EDB. These individuals are grandfathered under the pre-2020 stretch IRA rules.

Once EDBs no longer qualify as EDBs, e.g., minor child attaining the age of majority, or die, the 10-year rule is applied to them or to their beneficiaries.

Non-Eligible Designated Beneficiaries Subject to 10-Year Payout Rule

The second class of beneficiaries created by the SECURE Act are “non-eligible designated beneficiaries,” or “NEDBs.” These are designated, or named, beneficiaries who do not qualify as EDBs. Examples include children after reaching the age of majority, grandchildren, and some “look-through trusts,” a discussion of which is beyond the scope of this post.

NEDBs are no longer required to take RMDs from their retirement and IRA accounts. They are instead subject to the new 10-year rule whereby they must empty their accounts by the end of the tenth year after death.

Non-Designated Beneficiaries Continue to Follow Prior Law

Whereas EDBs and NEDBs are generally people, the third class of beneficiaries, “non-designated beneficiaries,” or “NDBs,” are entities. This includes estates, charities, or non-qualifying, i.e., “non-look-through” trusts.

The distribution rules for NDBs are unchanged. They are based on whether the IRA owner or plan participant dies before or after the owner’s “required beginning date,” or “RBD.” The RBD is generally April 1st after the year of the 72nd birthday.

If the owner dies before the RBD, the account must be withdrawn by the end of the fifth year after death. This is known as the 5-year rule. If the owner dies after the RBD, RMDs must be taken over the deceased IRA owner or plan participant’s remaining single life expectancy.

Distribution Shortfall Penalty

Whether you’re an EDB or NEDB or an NDB entity, the IRS penalty for shortfalls in meeting applicable distribution requirements is severe. The amount of the penalty, which is referred to by IRS as the “additional tax on excess accumulations,” is 50% of the shortfall. While a penalty waiver request can be submitted to IRS, it’s obviously better to avoid this situation.

The timing of potential penalties for eligible designated beneficiaries, or EDBs, continues to be determined and calculated based on annual RMDs since the stretch IRA rules still apply. The 50% penalty is relatively easy to avoid for EDBs since their distributions can be automatically calculated and distributed by financial institutions on the same day each year.

The 50% penalty for distribution shortfalls for non-eligible designated beneficiaries, or NEDBs, is more problematic. NEDBs are subject to the new 10-year rule that requires them to empty their accounts by the end of the tenth year after death.

Given what’s at stake, it’s imperative for NEDBs to track the 10-year rule as it pertains to each of their IRA and retirement plan accounts. This includes Roth IRA and Roth 401(k) plan beneficiary accounts. While distributions from the latter accounts are exempt from taxation, distribution shortfalls are subject to the 50% penalty.

Required Minimum Distributions Waived in 2020

Eligible designated beneficiaries, including surviving spouses and minor children, are exempt from the 10-year payout rule and must take distributions using the RMD rules. The good news is that the CARES Act which was signed on March 27th waives required minimum distributions, or RMDs, for 2020. The waiver applies to inherited traditional and Roth IRAs.

Which Type of Beneficiary Are You?

As strange as it seems, if you are the beneficiary of a retirement plan or IRA account that you inherited after 2019, you must first determine which of the three classes of beneficiaries you fall into in order to determine the required time frame for taking distributions from your account. This can be tricky and will likely require the assistance of a professional advisor who is familiar with the applicable rules.

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