The IRS’s recently updated rules for inherited IRAs are set to take effect on January 1, 2025, clarifying requirements on required minimum distributions (RMDs) and eliminating confusion surrounding the 10-year rule. These new regulations apply to traditional and Roth IRAs and are critical for beneficiaries to understand, as not following these rules can lead to significant tax penalties. Below, we’ll break down the main points of these rule changes, explain the tax implications, and offer guidance for navigating the complexities of inherited IRA distributions.

Secure Act’s Impact on Inherited IRAs and the Elimination of the “Stretch IRA”

Before the Secure Act, non-spouse beneficiaries of inherited IRAs could use the “stretch IRA” strategy to take distributions over their lifetime, extending tax-deferred growth for decades. However, the Secure Act (2019) replaced the stretch IRA approach with a 10-year distribution rule for most beneficiaries, mandating that inherited IRAs be fully distributed within 10 years of the original account holder’s death.

The reasoning behind this change was straightforward: Congress aims to accelerate the tax revenue collected from inherited IRAs by reducing the deferral period. While this change limits beneficiaries’ ability to enjoy prolonged tax-deferred growth, it also presents beneficiaries with more pressing tax planning needs.

Key Rule Changes for 2025: RMDs and the 10-Year Rule

1. 10-Year Rule:
   • Under the 10-year rule, most designated beneficiaries must fully withdraw inherited IRA funds by the end of the tenth year following the account holder’s death.
   • This rule applies to both traditional and Roth IRAs.
   • Prior to the new IRS rules, the law was not clear as to whether designated beneficiaries were required to take annual withdrawals in the first nine years. Now, beneficiaries need to be proactive in determining whether or not they are subject to annual distributions in addition to the 10-year rule.
2. Annual RMDs for Certain Beneficiaries:
   • For inherited IRAs where the original owner was taking RMDs prior to their death, beneficiaries must now take annual RMDs starting in 2025. Previously, beneficiaries could defer these annual distributions until the tenth year.
   • This annual RMD requirement applies whether the account holder was a regular designated beneficiary or an eligible designated beneficiary (EDB).
   • Failure to take RMDs can result in steep excise taxes, making it crucial for beneficiaries to stay informed and adhere to the annual distribution schedule.
3. Eligible Designated Beneficiaries (EDBs):
   • Certain individuals, such as surviving spouses, minor children of the original account holder, disabled or chronically ill beneficiaries, and beneficiaries less than 10 years younger than the deceased, are classified as Eligible Designated Beneficiaries (EDBs).
   • EDBs have the option to take distributions based on their life expectancy, which allows for continued tax-deferred growth and potentially reduces the immediate tax burden.
   • Minor children only retain EDB status until they reach 21 years of age, at which point they must switch to the 10-year rule, meaning they must empty the account by the time they are 31.
4. Designated vs. Non-Designated Beneficiaries:
   • Designated beneficiaries (typically individuals, such as family members) qualify for the 10-year rule and other more favorable terms.
   • Non-designated beneficiaries (e.g., estates or trusts) generally face a five-year withdrawal requirement if the account holder passed before beginning RMDs. This shorter window limits tax-deferred growth and accelerates tax liability.

Waived Penalties and the Excise Tax Implications

Due to the complexity of the new inherited IRA regulations, many beneficiaries have unintentionally failed to meet RMD requirements. Recognizing this, the IRS waived excise taxes for missed RMDs from 2021 to 2024. However, beginning in 2025, this penalty waiver will no longer apply, and beneficiaries who fail to take their required distributions will face an excise tax of up to 25% on the missed amount. If corrected promptly, this tax can be reduced to 10%.

Beneficiaries who made errors due to “reasonable cause,” such as misunderstanding the rule changes, may be able to request relief by filing IRS Form 5329. However, this process requires thorough documentation, and beneficiaries should seek the assistance of a financial advisor or tax professional to avoid costly mistakes.

Tax Implications of the New Inherited IRA Rules

The 10-year rule and the annual RMD requirements have distinct tax implications, especially for traditional vs. Roth IRAs.

1. Traditional IRAs:
   • Distributions from traditional IRAs are taxable as ordinary income. With the 10-year rule, beneficiaries may face large taxable withdrawals if they wait until the final year to withdraw all funds.
   • Spreading out distributions over the 10-year period can help manage income tax brackets and avoid a large tax bill in year 10.
2. Roth IRAs:
   • While Roth IRA distributions are tax-free, the 10-year rule still requires the entire balance to be distributed within a decade.
   • Since Roth accounts grow tax-free, beneficiaries may wish to keep the funds invested as long as possible, only withdrawing in year 10 to maximize tax-free growth.

Practical Guidance for Beneficiaries

Given the intricacies of the 2025 rule changes, beneficiaries should consult with financial and tax professionals to determine the optimal distribution strategy. Here are some key steps for beneficiaries to consider:

• Verify Beneficiary Classification: Understanding whether you’re a designated or eligible designated beneficiary determines your options for taking distributions.
• Plan Around Tax Brackets: For traditional IRAs, plan distributions to minimize the tax impact. Avoiding large distributions in a single tax year can reduce your overall tax burden.
• Roth IRA Planning: For Roth IRAs, it may be advantageous to defer withdrawals until the tenth year to maximize tax-free growth.
• Monitor Compliance: Failing to meet RMD requirements can result in severe tax penalties. Regular consultations with a financial advisor can help ensure you remain compliant with IRS rules.

Adapting to the New Rules with Financial Planning

The IRS’s changes to inherited IRA rules underscore the need for careful planning to avoid costly tax penalties and missed opportunities for tax-deferred or tax-free growth. Beneficiaries need to understand the distinctions between beneficiary classifications, the implications of the 10-year rule, and the annual RMD requirements to maximize their inheritance while minimizing tax liabilities.

Beneficiaries who have inherited an IRA in recent years or expect to in the near future should connect with a fiduciary financial advisor to fully understand their obligations and develop a plan that aligns with their financial goals. By staying informed and planning strategically, beneficiaries can make the most of their inherited IRA while navigating the updated IRS regulations effectively.