January 1, 2023
SECURE Act Proposed Regulations – Two Eligible Designated Beneficiary Surprises
Take-Away: Previously covered in the past has been the IRS’s unique interpretation of the at least as rapidly rule when it comes to distributions from an inherited IRA when the IRA owner was over their required beginning date (RBD) at the time of their death. A couple of other ‘surprise’ interpretations also appear in those SECURE Act Proposed Regulations with regard to a designated beneficiary who is not more than 10 years younger than the deceased account owner. Again, they create a risk that a beneficiary will fail to take their full required minimum distribution (RMD) leading to a 50% excise tax imposed on the amount that should have been taken from the inherited IRA.
Background: The SECURE Act Proposed Regulations that were issued last February contain some surprise interpretations. One which has been covered a lot (some might snarl that we are now into a ‘beating a dead horse’ realm) deals with the at least as rapidly rule, which requires annual required minimum distributions (RMDs) from an inherited IRA if the IRA owner was older than age 71 at the time of his/her death. That rule will not be covered again (thankfully!)
Two more interesting IRS interpretations also appear in the Proposed Regulations that deal with the eligible designated beneficiary category when the designated beneficiary is not more than 10 years younger than the deceased account owner. An eligible designated beneficiary can used their own life expectancy to determine their annual required minimum distributions (RMDs) which may considerably longer than the SECURE Act’s basic 10-year distribution period. These narrow interpretations are not likely to be encountered by most individuals, but they still exist and need to be considered when a beneficiary is advised what distribution rules apply to them.
10 Years is Not Counted by the Calendar Year: In the past, the IRS has ‘counted’ 10-year periods used in its Regulations on a calendar year basis. As an example, an IRA owner must use the Uniform Lifetime Table to determine the distribution period for calculating their required minimum distributions (RMDs.) The Uniform Lifetime Table assumes that the beneficiary is 10 years younger than the IRA owner. This 10-year age difference is determined on a calendar year basis. If the IRA owner is age 80, the age used for the owner’s designated beneficiary is age 70; both ages are determined as of the end of the calendar year for which the owner’s RMD is calculated.
Proposed Regulation: The SECURE Act’s Proposed Regulations note that when determining if a designated beneficiary is not more than 10 years younger than the IRA owner, the actual dates of birth of the IRA owner and the designated beneficiary must be used, not the calendar year of those births. A paraphrased example used in the Proposed Regulations follows: “If an account owner’s date of birth is October 1, 1953, then the account owner’s beneficiary is not more than 10 years younger than the account owner if the beneficiary was born on or before October 1, 1963.”
Before the Proposed Regulations, the not more than 10 years younger than would probably have been interpreted using a calendar year basis, and not an actual date-of- birth basis. Consequently, following the above example, if a designated beneficiary was born on October 2, 1963, they would likely have been told by their advisor that they were an eligible designated beneficiary and entitled to take annual RMDs from the inherited IRA over their life expectancy. Now, with the Proposed Regulations interpretation, the same designated beneficiary will be told that they are simply a designated beneficiary, not an eligible designated beneficiary, who is subject to the SECURE Act’s basic 10-year distribution rule. Thus, they are not able to take distributions from the inherited IRA over their longer single life expectancy.
Shorter Distribution for Older EDBs: An IRA owner who is beyond his/her required beginning date (RBD) might name an eligible designated beneficiary for their retirement account. In this situation, the distributions from the inherited IRA must be over the longer of the single life expectancy of the deceased account owner or the single life expectancy of the eligible designated beneficiary. Yet, despite that basic rule, the distributions taken from the inherited IRA cannot extend beyond the life expectancy of the eligible designated beneficiary.
Example: Barney, a traditional IRA owner, died at age 75, which means that Barney died after his required beginning date (RBD.) Barney’s designated beneficiary is his longstanding friend, Fred, age 80 years. Accordingly, Fred is an eligible designated beneficiary for Barney’s inherited IRA since Fred is not more than 10 years younger than Barney- Fred is older than Barney by 5 years. Because Barney is younger than Fred, and therefore he has a longer life expectancy than Fred based on the IRS Single Life Expectancy Table, Barney’s life expectancy of 14.8 years is used to calculate Fred’s annual RMD from the inherited IRA. However, Fred must fully distribute the inherited IRA when his own life expectancy, which is 11.2 years (again based on the current Regulations) is less than or equal to one. Consequently, if Fred takes no more than his RMDs using Barney’s life expectancy, he will have a relatively large lump sum at the end of his own life expectancy when compared to other distributions. So, while Fred can use Barney’s longer life expectancy to calculate RMDs from the inherited IRA, all remaining funds in the inherited IRA must be distributed to Fred when the end of his life expectancy (under the Single Life Table) is reached, thus bunching taxable income into one tax-year.
Conclusion: It should come as no surprise that most of the IRS’ interpretation of the SECURE Act result in an acceleration of taxable income distributed from an inherited IRA. Behind that acceleration of taxable income lingers the threat of a 50% excise tax imposed on the amount that should have been withdrawn but was not. And to help the IRS in its quest for current taxable income we have strange (nefarioius?) rules that will require experts in retirement distribution planning to answer in order to avoid mistakes. What a mess!