Take-Away: The SECURE Act imposed a 10-year distribution rule on most inherited IRAs (traditional and Roth.) However, the Act changed the required minimum distribution rules to eliminate annual required minimum distributions from an inherited IRA, only requiring that the inherited IRA be completely emptied by December 31 of the 10th year following the IRA owner’s death. The SECURE Act did not change, though, the imposition of the 50% penalty for the failure to take the required minimum distribution. Unfortunately, there is no one assigned to monitor and warn the beneficiary when that 10th anniversary date nears.

Background: There has been considerable commentary (especially from me, for which I apologize) on planning with regard to the SECURE Act’s ‘new’ rules for distributions from inherited IRAs. There has been far less commentary on the implications of the 50% penalty for the failure to take a required distribution. As noted, the SECURE Act imposed a new 10-year distribution rule, but it eliminated annual required minimum distributions (RMDs) by the beneficiary of an inherited retirement account. Instead, the Act simply requires that the inherited retirement account be emptied within 10 years after the IRA owner’s death. Thus, some beneficiaries may choose to permit the inherited retirement account to grow, tax deferred, for 10 years, before taking one, final, distribution of the entire balance of the inherited retirement account.

Problem: The problem is that retirement plan and IRA custodians currently have no obligation to monitor this 10th anniversary distribution deadline and alert the beneficiary of its date, or the ensuing 50% penalty that will be imposed if the deadline is missed.

50% Penalty: The law is clear that if an individual fails to take a required (minimum) distribution, a 50% penalty is imposed on the amount that should have been taken as a distribution. [IRC 4974.] If the beneficiary of an inherited IRA decides to wait until the 10th anniversary to take the balance of the inherited IRA, and they miss that deadline by one day, the 50% penalty is imposed on the entire balance of the inherited IRA. Thus, for an individual IRA owner who dies in June, 2020, their IRA beneficiaries are not required to take any distribution from the inherited IRA until December 31, 2030. If the distribution is taken on January 1, 2031, the beneficiary will face a 50% penalty of the entire balance of the inherited IRA.

Example: Homer dies this month with a $500,000 IRA. Homer designates his two children, Bart and Lisa, as his IRA beneficiaries. Bart and Lisa each decide to postpone taking any distributions from their inherited IRAs until the tenth anniversary of Homer’s death, i.e. December 31, 2030, to permit the investments in their respective inherited IRAs to grow tax-deferred. Assume the ‘rule of sevens’ applies to the growth of their inherited IRAs [pause, for the ‘eye roll’ from wealth managers], doubling in value every ten years, so that nearing the tenth anniversary of Homer’s death, each of Brad and Lisa’s inherited IRAs is now worth $500,000. However,  a lot can happen in 10 years. As the 10th anniversary of Homer’s death approaches, we find Lisa in a nasty divorce which is a major distraction in her life. Moreover, there is a court injunction that prohibits the transfer of ‘any assets’ during the divorce, which Lisa interprets to mean that she cannot touch her inherited IRA until her divorce concludes. As for Bart, we find now find him in a federal prison. Bart does not want to take any distributions from his inherited IRA since federal laws require Bart to use his own assets to defray the costs of his incarceration, not to mention that Bart may also have a court order of restitution to his crime’s victims. Both Bart and Lisa are aware of the 10-year deadline, but for their own reasons, they fail to empty their inherited IRA when the 10-year deadline arrives on December 31, 2030.

  • Or, with the passage of time, Lisa and Bart, (who is not particularly responsible to begin with) simply forget that they must pull all of their investments from their inherited IRA by December 31 of the 10th year after Homer’s death.  The IRA custodian has no duty to alert them to the consequences of their failure to timely empty their inherited IRAs.
  • The penalty that each of Lisa and Bart face is $250,000, to go along with the income tax liability associated with $500,000 of reported taxable income. Whatever growth Bart and Lisa may have enjoyed during their ten-year wait to harvest their inheritance from Homer can disappear in an instant if they miss taking the distribution of the entire inherited IRA account by just one day.
  • The likelihood of ‘blowing’ the 10-year distribution deadline is even greater if either Bart or Lisa die during the ten year period, naming their own children as successor beneficiaries of the inherited IRA (from Homer.) Those beneficiaries, i.e. Homer’s grandchildren, are even more likely to be unaware of the 10-year distribution deadline date.

Use a Trust: Following the prior example, what if Homer instead named a trust as the beneficiary of his IRA. Specifically an accumulation see-through-trust. The trustee could be charged under the trust with making no payouts to the trust beneficiaries, Bart and Lisa, for the first 9+  years after Homer’s death, then direct a full distribution of the IRA to Bart and Lisa (50%-50%) in the tenth year. The trust instrument could also give the trustee  discretion to make some distributions from the trust to Bart, Lisa, or both prior to the full depletion of the inherited IRA. The trust’s spendthrift provision would protect the inherited IRA, at least until the funds were distributed to Bart and Lisa, from their creditors. Under the trust arrangement, the trustee is charged with monitoring the 10-year distribution rule, not Bart or Lisa. The trustee can take the distribution emptying the inherited IRA by its 10-year distribution deadline even if Lisa is in the midst of a divorce, or Bart remains behind bars. In short, there is much less of a chance that the 10th anniversary distribution deadline will be missed if a fiduciary controls the IRA distribution.

The ‘Last’ RMD: While the above summary addresses the ability to defer taking distributions for 10 years after the retirement account owner’s death, there is one situation where the designated beneficiary will take some of the inherited IRA shortly after the IRA owner’s death. If the IRA owner is over age 72 and subject to the obligation to take required minimum distributions, and the RMD has not been fully taken in the year of the owner’s death, then the designated beneficiary must take the balance of the deceased owner’s RMD for the year of death. This ignores 2020 where the CARES Act has suspended all RMDs for one year.

Example: Edith, age 80, dies this month. Edith leaves her IRA to her 50 year old daughter, Gloria. Gloria is neither disabled, nor chronically ill. Consequently, Gloria is subject to the SECURE Act’s 10-year distribution rule. Gloria also has the option to delay taking any distributions from her inherited IRA until December 31, 2030. However, Edith had arranged to take a $3,000 distribution each month from her IRA in order to satisfy her required minimum distribution (RMD) for 2020. At the time of Edith’s death, she had taken seven months of distributions, or $21,000.  Ignoring for a moment that the CARES Act waives all RMDs for 2020, Gloria will be required to withdraw the $15,000 balance of Edith’s 2020 RMD from the inherited IRA by the end of 2020, or at least that is what is required from Gloria under the rules prior to the SECURE Act. Such would be the case if Edith died in June of 2021. With the CARES Act, Gloria will not have to take $15,000 in distributions in 2020 to complete her late mother’s RMD obligation for the year.

Conclusion: Probably not too many IRA beneficiaries will opt to delay taking any distribution from an inherited IRA for 10 years due to the ‘bunching’ of that taxable income into a single tax year. But for those who do decide to delay taking distributions (arguably an abbreviated form of a stretch distribution) the risk exists that the 50% penalty will be applied to a dramatically larger amount. If IRA custodians are not required to alert the beneficiary the to the looming deadline, then it remains to the beneficiary to monitor that deadline. Naming a trustee as the beneficiary of the retirement account might go a long way to protect the inherited IRA, not only from the beneficiary’s creditors, but also the beneficiary’s midlife distractions that could cause the deadline to be missed.