In February 2022 the IRS issued proposed regulations that surprised a lot of tax advisors and indicated a number of heirs incurred penalties for not taking actions they didn’t know about.
In early October the IRS said it would waive those penalties for 2021 and 2022.
The proposed regulations were issued under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, enacted in 2019.
The SECURE Act says that, except in a few cases, a beneficiary who inherits an IRA (either a traditional or a Roth IRA) must distribute the entire IRA within 10 years (the 10-year rule). In other words, the SECURE Act eliminated the Stretch IRA that allowed a beneficiary to distribute the IRA over his or her life expectancy.
Before the proposed regulations, most tax advisors believed the 10-year rule meant the beneficiary could distribute the IRA in any pattern he or she wanted as long as it was fully distributed within the 10 years.
The 10-year rule is interpreted differently under the proposed regulations.
If the deceased owner hadn’t reached his required beginning date (RBD) for required minimum distributions (which is April 1 of the year after he or she turns age 72), then the beneficiary can take distributions however he or she wants as long as the IRA is fully distributed within 10 years.
But if the IRA owner had reached the RBD, then the beneficiary must take at least minimum annual distributions in each of the first nine years after inheriting the IRA. The remainder of the IRA must be fully distributed by the end of the tenth year.
The annual distributions during the first nine years are determined using the pre-SECURE Act rules, which generally means the distributions are computed using the beneficiary’s life expectancy.
The proposed regs indicate that they are effective when the SECURE Act became effective at the start of 2020, though the regulations weren’t issued until February 2022. That means some IRA beneficiaries were required to take distributions in 2021 and 2022. They didn’t know about the requirement but still would owe penalties for not taking the distributions.
That’s why the IRS said it would waive the penalties for 2021 and 2022 for beneficiaries who didn’t take the distributions as required under the proposed regulations. The IRS also said that anyone who already paid a penalty for not taking a distribution can apply for a refund of that penalty.
But the IRS did not say that someone who took a distribution in 2021 or 2022 because of the proposed regulations can return that money to the IRA or claim a refund of taxes paid on the distributions.
Under the IRS notice, the first distributions by beneficiaries don’t have to be taken until 2023 and perhaps later, depending on when the final regulations are adopted and what they say.
The IRS also indicated that it plans to finalize the regulations soon, perhaps by the end of 2022 or in early 2023.
A number of tax professionals who commented on the proposed regulations asked the IRS to change its interpretation of the 10-year rule to the one that was widely-accepted before the proposed regulations were issued.
The wording of the penalty waiver doesn’t give a hint how the IRS will respond to those requests in the final regulations. Some tax professionals say waiving the penalties means the IRS is likely to change its interpretation. Others say it means the IRS plans to continue its interpretation but realizes imposing it retroactively is unfair.
But the announcement gives IRA owners and beneficiaries more time to plan IRA distributions. They don’t have to rush to take distributions by the end of 2022 or try to make up for 2021 distributions that weren’t taken.
The proposed regulations show the importance of long-term IRA distribution planning. Long-term planning for IRAs can reduce the total taxes a family pays on IRA balances and increase a family’s after-tax wealth. The 10-year rule increases the income taxes paid on some inherited traditional IRAs by forcing them to be distributed faster than the beneficiaries want and potentially pushing them into higher tax brackets.
IRA owners who are concerned about this should consider repositioning their large traditional IRAs as Roth IRAs, permanent life insurance, and charitable remainder trusts. Paying income taxes now at today’s fairly low rates could reduce the family’s total income taxes over time and increase after-tax wealth.