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Recent heirs to retirement plans got an unexpected boost when the Internal Revenue Service suggested that they could skip making required withdrawals for this year and last, a reprieve that eliminates one-time tax hits and leaves more money in a nest egg to grow.
The tax agency surprised wealth advisors late last Friday when it announced that people wouldn't face an onerous 50% penalty for not taking minimum distributions from inherited plans, such as individual retirement accounts, for 2022 and 2021. Though the IRS didn't spell things out directly and said final rules would come next year, the announcement appears to mean that heirs are permanently off the hook for withdrawals for those two years.
"The IRS is now saying there will be no 50% penalty for not taking those RMDs, which to me appears to mean that these RMDs do not have to be taken (even though the IRS did not specifically state that in the notice)," said Ed Slott, a certified public accountant and retirement expert in Rockville Centre, New York.
The news jolted estate planners just as the annual rite of required minimum distributions, or RMDs, kicks into gear for millions of Americans amid a recent change in how retirement plans pass to heirs. Under a 2019 law, beneficiaries who aren't spouses, minor children, chronically ill, disabled or not more than 10 years younger than the plan's owner must drain inherited accounts, whether traditional or Roth, within 10 years. Before, heirs could "stretch" out withdrawals over a lifetime. The law hits beneficiaries of inherited plans whose original owner died after 2019.
Withdrawals from traditional IRAs and 401(k)s, whose contributions are made with dollars on which taxes haven't yet been paid, are taxed at ordinary rates, now a top 37%. Not making a minimum withdrawal, also known as taking a distribution, each year sparks a 50% penalty , plus interest, on the minimum amount not taken.
Although putting money into alternative assets is already legal, some hesitate to do it because of perceived legal pitfalls.
The prior "stretch" system was a key tool for boosting wealth because it allowed assets to grow in value over a longer period of time. A separate law canceled all RMDs from defined contribution plans, including inherited ones, for 2020, amid the COVID-19 pandemic. Combined with the two-year reprieve, some heirs won't have to take three out of 10 years' worth of distributions.
That means more money can compound over a decade. But it can also create what Scott Bishop, the executive director of wealth solutions at Avidian Wealth Solutions in Houston, called a "tax time bomb," in which heirs pay one-time larger tax bills because they have to pull out larger amounts over a shorter period of time. Heirs to Roth plans, which are funded with dollars on which taxes have already been paid, don't owe any tax on withdrawals, but they still have to drain the accounts within 10 years.
The 10-year rule is a major shift for the estate planning industry. But the IRS has flip-flopped on how it will work, and even with the new reprieve, it still hasn't issued final rules. Those are still forthcoming, the agency said in its Oct. 7 notice , and they will "apply no earlier than 2023, it said.
"Do NOT confuse…"
What's clear for now in the IRS's reprieve is that heirs who aren't a surviving spouse, chronically ill, disabled or a child don't have to make minimum withdrawals this year and last before draining the accounts within 10 years. While spouses, sick people and children must still take required annual distributions, including for 2021 and 2022, they can do so over their lifetime ; a child gets hit with the 10-year rule once he turns 18.
"With this recent IRS drop, we now know that we do not have to have taken the 2021 RMD and won't need one for 2022," Bishop said. He sent clients a note on Oct. 10 saying, "Do NOT confuse this with IRAs inherited BEFORE 2020, where RMDs ARE still required annually for beneficiaries based on their life expectancy. "
The notice makes clear that beneficiaries that are trusts, estates and charities are off the hook for withdrawals for 2021 and 2022. Timothy Steffen, the director of tax planning at Baird in Milwaukee, said that "the really big news" is that so are adults and grandchildren who are able-bodied and well.
The federal government wants to make sure that it gets tax revenues from retirement nest eggs and that people don't accumulate massive accounts that pass tax-free to their heirs. So it requires owners of non-inherited IRAs, 401(k)s and other defined-contribution plans whose tax bills are deferred until withdrawals are made to pull out a minimum each year once they reach age 72, whether they're retired or still working.
Taxpayers must generally take a required first distribution by April 1 of the year after they reach age 72. No annual withdrawals are required for original, living owners of Roth plans because they're funded by dollars on which taxes have already been paid. A 2019 law raised the age at which taxpayers must make their first withdrawal to 72 from 70½ — though taxpayers born before July 1, 1949, are subject to the lower age limit.
Older people who are ignoring "the Great Resignation" and are still employed and contributing to an employer-sponsored retirement plan can delay a first withdrawal from that account — but not from any others — until the April 1 after they retire, according to Fidelity Investments.
Some older Americans worry that if they return to work, they'll get less money from Social Security. In fact, the opposite is true — but advisors need to get the word out.
The minimum amount that has to be withdrawn is calculated by dividing the balance at the end of the prior year by what the IRS calls a "life expectancy factor." With markets down sharply since the end of 2021, the math is likely to hurt millions of taxpayers, who will have to take out a larger chunk of their plan than expected and pay taxes on the withdrawal.
Withdrawal amounts start at roughly 3.5% or so a year and increase as a taxpayer gets older, according to Personal Capital Advisor, an independent wealth management firm in Redwood City, California. So a 72-year-old with an IRA worth $500,000 at the end of last year would need to pull out just over $18,200 for this year, or just over 3.6%, according to the American Association for Advancement of Retired People.
If that IRA is invested in the S&P 500, which is down just over 24% so far this year, it's now worth only $380,000 and the withdrawal now represents 4.8% of the nest egg — close to the upper end of the 4% to 5% range that Fidelity says retirees can safely tap without worrying about running out of money.
The 2020 break on distributions was clear. But wealth advisors were left in the dark on RMDs from inherited plans for 2021. That's because the IRS has changed its mind so many times on the issue.
In early 2021, the agency said that annual withdrawals would be required in years one through nine before an inherited account is emptied in year 10. Then months later it said the opposite. Last February, it shocked advisors and accountants by saying it had made a mistake and that annual distributions were, in fact, required in years one through nine.
But because that last proposal was a proposal, and not a finalized rule, advisors didn't know whether to tell clients who are heirs to make a withdrawal for 2021. The Oct. 7 notice makes clear that they don't have to for that year or for 2022. But is also left open a scenario in which heirs could be forced to make taxable "catch-up" withdrawals by year 10.
"I suppose that opens the possibility of them being delayed beyond 2023, but that doesn't seem likely," Steffen said.
For many advisors, the lingering uncertainty is throwing a wrench into estate planning techniques used for decades. The IRS is under fierce criticism and lobbying by the tax and wealth management industries to make the rules of the road clear.
"This RMD confusion is still an evolving process," Slott said. "The IRS issued this temporary patch, but final regulations are coming that could contain more changes."