Beneficiaries May See Changes With New '10-Year Rule'
By Jodie Norquist, CIP, CHSP
When the IRS released its highly anticipated proposed regulations related to required minimum distributions (RMDs) in late February, the 275-page document included a new interpretation of the 10-year rule for certain IRA and retirement plan beneficiaries.
In short, some beneficiaries who elect the 10-year rule may soon be required to take annual payments—in addition to depleting the account in 10 years. This guidance seems to expand the new 10-year rule, which is found in the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019.
Let’s first examine the 10-year rule and how it’s been applied since 2020.
The Industry’s Interpretation of the 10-Year Rule
As of January 2020, the SECURE Act eliminated life expectancy payments as a payout option for many beneficiaries. Currently, only a few types of beneficiaries can “stretch” payments over their own lifetime—or base payments on the decedent’s age in the year of death. Most nonspouse beneficiaries must now distribute their entire account balance by December 31 of the year containing the 10th anniversary of the account owner’s death.
Certain beneficiaries, called “eligible designated beneficiaries,” are still allowed to take life expectancy payments. They may also elect the 10-year rule. Eligible designated beneficiaries include
the account owner’s spouse,
an individual who is not more than 10 years younger than the account owner,
a disabled or chronically ill individual, and
the account owner’s minor child.
The proposed RMD regulations also treat designated beneficiaries of account owners who died before January 1, 2020, as eligible designated beneficiaries.
For deaths that occur on or after January 1, 2020, most industry professionals believed that beneficiaries who chose the 10-year rule were not required to take annual distributions during the first nine years.
Example: If an IRA owner died on March 20, 2022, it was assumed that the beneficiary could move the assets into an inherited IRA and have until December 31, 2032, to deplete the account balance—without any other requirements. Any assets remaining in the inherited IRA after that date would be subject to a 50 percent excess accumulation penalty tax.
The 10-year rule appeared to make beneficiary options easier for financial organizations to administer because they no longer had to calculate life expectancy payments for beneficiaries subject to this rule. But this may soon change for some beneficiaries.
The IRS’s Interpretation of the 10-Year Rule
The proposed RMD regulations confirm that the 10-year rule is similar to the existing 5-year rule for nonperson beneficiaries, for Roth IRA beneficiaries, and for Traditional IRA and retirement plan beneficiaries of account owners who die before their required beginning date (RBD).
Example: Ben (age 62) died in February 2022. Ben had named his son Mark (age 35) as the sole primary beneficiary of his Traditional IRA. Because Ben died before his RBD, Mark can wait until December 31, 2032, to distribute his entire inherited IRA balance.
But the proposed RMD regulations contain one unexpected change: if an account owner dies on or after the RBD, beneficiaries who are subject to the 10-year rule must also take annual distributions during the first nine years. These distributions are based on the longer of the deceased account owner’s age or the beneficiary’s age.
Example: Betty (age 75) died in March 2022. Betty’s daughter Marissa (age 48) is the sole primary beneficiary of her Traditional IRA. Under the proposed RMD regulations, Marissa is subject to the 10-year rule, so she would have until December 31, 2032, to distribute her entire inherited IRA. But she would also need to take annual minimum distributions for the first nine years (based on her single life expectancy, nonrecalculated), and then distribute the remaining balance in year 10.
“Hypothetical” RMDs and the 10-Year Rule Changes for Spouse Beneficiaries
Assume that an account owner dies before the RBD and has a spouse beneficiary who elects the 10-year rule. The spouse may need to take a “hypothetical RMD” if she decides to roll over the remaining inherited assets to her own IRA before the last year of her 10-year window but in the year that she turns age 72 or older. (This rule seems to reduce the temptation of a spouse electing the 10-year rule to avoid any taxable distribution for nine years—and then rolling over the assets to her own IRA.) The hypothetical RMD is the amount that the spouse beneficiary would have been required to distribute had she been taking life expectancy payments upon reaching age 72. This hypothetical RMD is ineligible for rollover treatment.
Example: Gary (age 65) died on April 2, 2022, leaving his 401(k) plan to his wife, Christine (age 64). Christine elects to keep the assets in the plan under the 10-year-rule. On May 2, 2031, Christine (now age 73) decides to roll over the assets to her own IRA. But before she does this, Christine must calculate her two hypothetical RMDs, based on her single life expectancy in the years she would have taken RMDs at age 72 and at age 73. Because the sum of her hypothetical RMDs is ineligible to roll over, she must distribute that amount before rolling over the remaining balance to her own IRA.
The Next Steps
Although most of the SECURE Act provisions became effective on January 1, 2020, these regulations are proposed to become effective on January 1, 2022. For 2021, the preamble to the proposed regulations states that taxpayers must apply the existing regulations and exercise a “reasonable, good faith interpretation” of the increased RMD age and 10-year rule created by the SECURE Act. Compliance with the proposed regulations will satisfy that requirement.
The IRS is now requesting public comments through May 25, 2022, on the proposed RMD regulations. A public hearing is scheduled for June 15, 2022, to address those comments. After that, it may take several months until the IRS releases the final regulations.
Because the regulations are proposed to become effective January 1, 2022, this may be a good time to review the proposed regulations before they become permanent. If your clients are unsure whether they should take an RMD this year in light of the proposed 10-year rule changes, they should consider seeking competent tax advice before making a decision.
