In July 2024, final IRS regulations impacting the distribution of inherited individual retirement accounts (IRAs) were issued. The new requirements significantly change the distribution rules for beneficiaries and how they will manage their inherited funds starting in 2025. These changes come in response to the Secure Act 2.0, a sweeping piece of retirement legislation passed at the end of 2022. In particular, Required Minimum Distribution (RMD) adjustments will substantially impact how and when those beneficiaries must start withdrawing funds from inherited IRAs.
The Old Rules vs. The New Rules
Under the previous rules, beneficiaries of inherited IRAs had a variety of options for how and when to withdraw funds. For many individuals, the "stretch IRA" strategy was popular, allowing them to take RMDs based on their life expectancy, which allowed the inherited IRA to continue growing tax-deferred for many years. However, this strategy was eliminated for most non-spouse beneficiaries by the Secure Act of 2019, which required that funds be distributed within 10 years of the original account holder's death.
Prior to July 2024, beneficiaries could still choose to take distributions at any time within that 10-year period, with no RMD schedule. The only stipulation was that the account needed to be emptied by the end of the 10th year after the original account holder’s death.
The 2025 Shift: RMDs Required for Non-Spouse Beneficiaries
This new rule applies to accounts inherited from January of 2020. Starting in January 2025, inherited IRA rules will tighten further, especially for non-spouse beneficiaries. Most notably, beneficiaries must begin to take RMDs. This is a major shift from the previous rule, where beneficiaries had no specific annual withdrawal requirement during the 10-year window, only a final deadline.
Consequently, non-spouse beneficiaries must begin to withdraw at least a portion of the inherited IRA balance every year, even if they don't need the funds for living expenses. These distributions will be taxed as ordinary income in the year they are taken, which could result in a larger tax bill, especially for beneficiaries who are in higher income tax brackets.
Exceptions to the Rule
While the new RMD requirement applies to most non-spouse beneficiaries, there are a few exceptions. Spousal beneficiaries, for instance, still enjoy more flexibility in how they handle inherited IRAs, including the option to treat the IRA as their own. Additionally, certain other eligible beneficiaries, including minors (until they reach the age of majority) and individuals with disabilities or chronic illnesses, may have exceptions or more favorable distribution schedules.
Why This Matters - Inherited IRAs
For non-spouse beneficiaries, the new RMD rules will have important tax implications. The IRS is aiming to ensure that inherited IRAs are not simply a vehicle for accumulating tax-deferred wealth. By requiring annual RMDs, the new rules prevent beneficiaries from waiting until the 10th year to make withdrawals, ensuring that IRA funds are distributed over a more predictable timeline. This change could impact the timing of withdrawals and affect how beneficiaries plan for their own long-term financial needs.
The introduction of RMD changes in 2025 is also likely to impact estate planning strategies, as beneficiaries may now face larger tax liabilities due to the requirement for regular distributions. This could influence decisions around IRA planning for those leaving funds to heirs, and how beneficiaries might manage distributions to minimize taxes.
The IRS changes to inherited IRA rules starting in 2025 are designed to ensure that beneficiaries take more structured withdrawals from inherited accounts. Affected clients should consult with their accountant and evaluate the leverage that can result from paying taxes now and funding life insurance for more efficient wealth transfer from G1 to G2. Let's schedule a time to talk about strategies to optimize wealth transfer planning for your family.
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