RMDs: To Take, or Not to Take, that is the Question

Take-Away: The SECURE Act’s new 10-year distribution requirement requires present value calculations to determine whether it is best to defer taking any distributions from an inherited IRA until the tenth year, or to take distributions each year from the inherited IRA, or in some other pattern.

Background: The Tax Code essentially provides two different situations in which an individual who inherits an IRA (or qualified plan account) must take distributions in order to avoid the 50% excise tax imposed on the failure to take a required minimum distribution (RMD.) [IRC 401(a)(9).]

– Death Prior to Required Beginning Date: If the IRA owner dies prior to age 72, i.e. his or her required beginning date (RBD), if there is no designated beneficiary of the IRA, then the 5-year distribution rule applies and the inherited account balance must be emptied by December 31 of the year in which the 5th anniversary of the account owner’s death occurred.

If there is a designated beneficiary of the IRA, then the SECURE Act’s 10-year distribution rule applies, where the inherited IRA must be emptied by December 31 of the year in which the 10th anniversary of the account owner’s death occurred.

– Death on or After Required Beginning Date: If the IRA owner dies after attaining age 72, then the 5-year distribution rule does not apply. However, the SECURE Act’s 10-year distribution applies.

Two exceptions are available in this situation if there is a designated beneficiary when the owner dies after his or her required beginning date:

First, the designated beneficiary may take annual distributions using the deceased IRA owner’s ghost life expectancy, which may be a bit longer than 10 years, e.g. the IRA owner dies at age 73.

Second, if the designated beneficiary qualified as an eligible designated beneficiary [spouse; minor child of the IRA owner; disabled; chronically ill; less than 10 years younger than the IRA owner] then that eligible designated beneficiary can use his or her own life expectancy to take annual RMD’s from the inherited IRA. [That is, until the minor attains emancipation or until the disability or chronic illness disappears; upon those events the 10-year distribution rule then kicks in.]

When to Take Distributions from the Inherited IRA: The general ‘rule-of-thumb’ is that withdrawing taxable funds from an inherited IRA later is generally better, than sooner, as the income tax deferral tends to maximize value. However, there is the need to balance the value of that income tax deferral against the federal income tax regime’s progressive tax rate scale.

– The decision is fairly easy if the designated beneficiary is currently at the top marginal federal income tax rate with their own income, as the maximum deferral of the income tax by waiting to take a distribution from the inherited IRA will create the maximum value.

– If the designated beneficiary has other taxable income that does not incur an income tax at the maximum federal and state income tax rates, the question then becomes whether to spread the taxable income from the inherited IRA over the 5 or 10-years in order to take advantage of each year’s run-up in the federal income tax rate scale.

Present Value Calculations: For those designated beneficiaries who are not at the highest marginal federal income tax bracket, they will need to explore present value options through detailed financial modeling that can lead them to the best decision. In order to do so, they will need to estimate the net after-tax present value of annual cash flows that result from the available income tax deferral under two separate scenarios.

– First Scenario: The first is to calculate the present value if no distribution was taken from the inherited IRA until the end of the year that contains either the 10th or the 5th anniversary of the IRA owner’s death. Then calculate the net after-tax present value of that lump sum distribution.

– Second Scenario: The second is to calculate each year prior to the final year (either the10th or the 5th) withdrawal of only enough near the end of each and every year in an amount that will cause application of all available income tax brackets below the top marginal federal income tax rate. This is often referred to as tax bracket management. Then calculate the net after-tax present value of each annual distribution from the inherited IRA, and add them.

A comparison of the two after-tax amounts will provide some guidance to the individual who inherits the IRA as to how to proceed with taking the taxable distributions.

Charitable Remainder Trust as Option: As has been previously covered, a third option may exist for those IRA owners who are charitably inclined, which is to name a charitable remainder trust as the designated beneficiary of their IRA. [IRC 664.] The IRA is fully emptied with a lump sum distribution to the charitable remainder trust, tax-free. The trust then makes annual taxable distributions of the former IRA assets to its individual beneficiary.  This results in what is the equivalent of a quasi-stretch distribution, where the trust makes distributions over the individual trust beneficiary’s lifetime (not the 5 or 10 year maximums noted above), with the remainder of the trust then passing to charity on the individual beneficiary’s death.

– Normally a charitable remainder trust will require annual distributions from 5% to 50% of the trust’s assets [either in the form of an annuity amount, or a unitrust amount that adjusts annually dependent upon the value of the charitable trust’s assets at the end of the prior calendar year) either for the beneficiary’s lifetime or a fixed term of no more than 20 years.

– In addition, 10%  percent of the initial value of the IRA distributed to the charitable remainder trust must be assured to pass to the charity that is named the remainder trust beneficiary.

– As a result of the 5% minimum distribution to the individual beneficiary and the required 10% of the initial amount transferred assured to the charitable remainder beneficiary, some individuals who are young may disqualify the charitable remainder trust and the income tax benefits that go along with naming the charitable remainder trust as the IRA’s beneficiary.

– Currently, with the low AFR rates used to value the annuity or unitrust interest of the individual beneficiary, if the lifetime beneficiary of the charitable remainder trust is age 28 or younger, the trust will not qualify as a charitable remainder trust. Note, too, that when the new life expectancy tables become applicable in 2022, that minimum age required for the individual trust beneficiary will increase even higher. [Regulation 1.664-4, Table U(1).]

Conclusion: The SECURE Act eliminated stretch required minimum distributions for most beneficiaries of inherited IRAs. The 5-year and 10-year distribution rules may be easier to understand than annual required minimum distributions pre-SECURE Act, but the decision whether to delay taking any distribution for 10 (or 5) years from the inherited IRA,  or to take distributions during those periods requires a present value calculations. Most wealth management advisors should be capable of running those present value calculations.