IRS to fix its confusing tax ‘error’ on new 10-year rule for inherited retirement plans

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Congress dealt investors a blow on the eve of the pandemic when it sharply reined in the benefits of a lucrative tool for passing on wealth to heirs, sometimes tax-free. Then the IRS tightened the screws, shocking advisors and estate planners in March when it suggested that the new “10-year rule” for inheritors of so-called stretch IRAs and 401(k)s could create immediate tax hits for some beneficiaries.

Now the IRS is reversing course. After quietly publishing guidance that said non-spousal heirs would have to take annual minimum distributions from inherited plans before cashing them out after 10 years, the agency admits — not officially, yet — that it made a whopper of a mistake.

Though such beneficiaries can no longer “stretch” out the potential tax hit of withdrawals by spreading them out over their lifetime, and must take out all assets in inherited plans within 10 years of the original owner dying (starting in 2020), no annual distributions are required.

“Yes, we are aware of the error,” an IRS spokesman tells Financial Planning in an email, referring to the agency’s publication on March 25 of its latest rules for withdrawals from retirement plans, which included a confusing example in which plan heirs must take out minimum sums of money each year. “We are working on an updated version of the publication that will include a corrected example.”

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A few advisors and tax specialists had heard privately in conversations with IRS employees in recent weeks that the IRS had simply messed up and would correct itself. The spokesman said the agency is “uncertain” when it will update its rules, which appear in a publication consulted routinely by financial advisors, accountants and tax lawyers: “We hope to be able to do it soon.”

The tightened rules for inherited retirement plans are part of the SECURE Act, legislation that Congress passed in December 2019 to jumpstart retirement savings for Americans who aren’t wealthy.

Even before the IRS’s misleading guidance, some advisors of wealthy clients, and even the AICPA, the trade group and lobby for accountants, were concerned and confused.

The reason: in requiring non-spousal beneficiaries to cash out inherited plans within 10 years as of the start of 2020, the new law can leave certain heirs, like children or grandchildren, with a hefty income stream that can not only raise their federal income tax bill but push them into a higher tax bracket, especially if they’re still in their peak earnings years and already making solid income. One observer called it “an estate planning catastrophe for people with significant IRAs” and “a college-planning nightmare for middle-income parents.”

There’s no readily available data on how many inherited plans are “stretched” over decades. Retirement expert Ed Slott suspects that they’re not very common, as it’s “human nature” to want to cash out immediately. “People don’t wait more than 10 years,” he says. “In the real world, most people grab the money on the way to the funeral before the body is shown.”

He adds that “it was obvious that the IRS was sloppy and just cut and pasted the rules from prior years and never read the SECURE Act” and that “anybody who relied on that thing has to be totally out of their minds.”

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Still, the agency’s mistaken guidance barely two months ago “has everybody in a tizzy,” says Laura Zwicker, the chair of the private clients services group at law firm Greenberg Glusker in Los Angeles: “Absolutely, it is causing confusion.” Vanguard says that its automated RMD service doesn’t track whether clients’ plans are subject to the 10-year rule, and that clients have to consult a tax advisor. Beneficiaries not hit by the rule include a child who has not reached the age of majority, which is 18 in most states; a disabled or chronically ill person; or a person close in age to the deceased plan owner — not more than ten years younger.

To be sure, advisors have had cause for concern for their wealthy clients. Long-standing IRS rules severely whack investors who don’t take required minimum distributions (RMDs). Those who don’t take them owe tax, at ordinary rates, on 50% of the amount not withdrawn.

Withdrawals from traditional IRAs and 401(ks) are taxed at ordinary rates, now topping out at 37% and potentially going up to 39.6% under President Joe Biden. Original owners of Roth IRAs don’t face RMD requirements, but those of Roth 401(k)s do. And withdrawals from Roth plans — of principal or investment gains — don’t face a tax hit before or after the new law, as contributions are made with money upon which an investor has already paid tax. Federal law waived required RMDs for all of 2020 to help Americans deal with the impact of the COVID pandemic, but the distribution requirement is back on the books for 2021.

Still, the new 10-year rule applies to inherited Roth IRAs as well as their 401(k) cousins. “If you inherit an IRA or 401(k) from someone other than your spouse,” says a Fidelity Viewpoints note to clients, “the SECURE Act could impact your retirement savings plans or strategies to transfer wealth to future generations.” Another wild card: delaying withdrawals can expose an investor to a market downturn.

Jack Garniewski, Jr., a CPA/PFS and CFP and the president of Family Office Solutions in Wilmington, Delaware, says that the 10-year rule makes the challenge of “tax bracket management” more pressing: “I don’t want to skip from 22% to 32%” when cashing out an inherited plan, he says. “Hopefully, you’re older and not working and are in a lesser bracket.” As such, timing withdrawals to avoid bracket creep “is like, ‘How much sugar do I put in my coffee?’”

The SECURE Act made other changes to retirement plans that will remain in force. It raised the age at which original holders must take RMDs, to age 72 from 70 ½. It also allowed penalty-free withdrawals from IRAs and 401(k) of up to $5,000 for new parents; all others must wait until age 59 ½ or pay an additional 10% tax.