Beneficiaries of legacy retirement accounts avoid a tax bullet

New tax legislation can have many ambiguities and complexities, but the IRS often irons out these in the regulations it proposes.

Al Drago/Bloomberg


Sometimes these efforts fail to stem the confusion. This was the case with the IRS proposed settlement for the Secure Act, which left IRA beneficiaries, accountants and financial advisers scratching their heads.

Before the Secure Act passed in late 2019, beneficiaries of legacy retirement accounts — such as IRAs, 401(k), 403(b), and 457 — had to take required minimum distributions, or RMDs, each year based on their life expectancy. If a beneficiary was younger, the RMD amounts would be lower due to their longer life expectancy. The term “stretching the IRA” has emerged, defining the practice of extending an inherited IRA over many years.

“This was a powerful strategy to defer taxes and distributions for as long as possible,” said Eric Bronnenkant, CPA and chief tax officer at robo-advisor Betterment. “Notably, taxpayers who inherited retirement accounts before 2020 are grandfathered under the old rules.”

But the Secure Act brought major changes. It required ineligible designated beneficiaries to liquidate the assets of an inherited retirement account within 10 years. The The IRS defines these beneficiaries such as anyone other than a “surviving spouse, disabled person, chronically ill person, minor child or person no more than 10 years younger than the account holder”.

In late February 2022, the IRS finally released its draft RMD regulations for legacy retirement accounts. The department said not only do beneficiaries have to liquidate the assets within 10 years, but they have to make a distribution – based on life expectancy – for each year of the 10-year term. Otherwise, they would be subject to a onerous 50% excise tax on the amount that should have been withdrawn.

“Given that taxpayers and their advisors did not see this rule coming, and furthermore since the settlements are not even final yet, it is unlikely that many beneficiaries will have taken the required distributions,” said Steve Parrish. , co-director of the Center for Retirement Income. at the American College of Financial Services. “Unless these taxpayers had a time machine – or a mole inside the treasury – it’s hard to see how they would know the unknowable.”

To remedy this situation, the The IRS issued a notice Last week. “It has suspended the application of the proposed regulations until January 2023 at the earliest,” said Adam Frank, head of wealth planning and advice at JP Morgan Wealth Management. “No excise tax will be imposed on individuals who inherited IRAs after 2019 and did not make a minimum distribution in 2021 or 2022.”

What if you happen to pay an excise tax? You can file an amended return to get a refund.

Regardless of the tax relief, that doesn’t necessarily mean your clients have to forgo distributions just yet. “For beneficiaries who are in a lower tax bracket, it may make sense to start receiving legacy IRA distributions,” said Kevin J. Brady, CFP and vice president of Wealthspire Advisors. “Otherwise, they could be forced to receive larger distributions in subsequent years, which would push them into a higher tax bracket.”

Keep in mind that the final rules for legacy retirement accounts are still unsettled. But the IRS is expected to issue them by the end of the year or early 2023.

But if the government decides to require annual distributions in the final rules, which seems likely, there are some estate planning considerations to consider. One is a Roth conversion before death, so your beneficiaries inherit a Roth IRA. Converting from a traditional IRA to a Roth has an immediate tax impact, but future withdrawals are tax-free.

“This can make sense for parents who are in a lower tax bracket than their children,” said Michelle J. Gessner, CFP and owner of Gessner Wealth Strategies. “Otherwise, those funds will inevitably flow to survivors who will be subject to those tax rules, which effectively distribute about 40% of the money to the IRS instead of allowing it to stay in the families that own them.”

Tom Tauli is a freelance writer, author and former broker. He is also the author of the book, The tech pro’s guide to personal finance.

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