New tax laws are confusing, both for ordinary savers and for the affluent. Turns out they can also flummox financial advisors.
The wealth management industry is offering conflicting and incomplete advice on how a recent change to inherited retirement plans works. At stake is whether some of the accounts can potentially double in size before they must be drained or instead are consigned to more modest growth.
A 2019 federal law fundamentally changed how retirement plans pass to beneficiaries. People who inherited individual retirement accounts and 401(k)s used to be able to “stretch” out their required minimum withdrawals, or RMDs, over their lifetimes.
But since 2020, recent heirs who aren’t a spouse, minor child, disabled or sick person or more than 10 years younger than the original owner — perhaps a sibling — must drain an inherited plan within 10 years of the original owner’s death.
Spouses who inherit a traditional IRA after 2019 aren’t hit by the 10-year rule as long as they make a spousal rollover that stuffs the inherited plan into an existing IRA. The move makes the surviving spouse the owner of the entire account, not a beneficiary of the inherited one, and RMDs start at age 72.
But non-spousal heirs must take annual distributions regardless of their age and drain the account by year 10, according to a proposed rule from the Internal Revenue Service last February. When the original owner hadn’t yet begun taking RMDs, the heir can wait until the end of the 10-year term to empty the account.
The big question now consuming financial advisors: Are RMDs also required for inherited Roth IRAs?
“This is not an easy topic,” said Hayden Adams, the director of tax and wealth management for the Schwab Center for Financial Research. “It’s actually causing a lot of angst for a lot of people.”
Withdrawals from traditional IRAs, which are funded with dollars on which taxes haven’t yet been paid, are taxed at ordinary rates, now a top 37%; the penalty for not taking one is a half of the money not taken. Taking out dollars each year leaves less money to compound before heirs hit by the 10-year rule have to clear out the accounts. And withdrawals from larger accounts can be big enough to push a retirement saver into a higher tax bracket, increasing her federal income tax bill.
By contrast, withdrawals from Roths have always been tax-free because they’re funded with dollars on which taxes have already been paid. A non-spousal beneficiary to a Roth — say, a daughter or a brother — still must drain the account within 10 years. But some wealth advisors say that the IRS’s February proposal doesn’t make the question of annual distributions entirely clear when a Roth is inherited by someone other than a spouse or other so-called “eligible designated beneficiary.”
“There’s a lack of clarity — does this also cover Roths? We’re not 100% sure,” Adams said.
Firms including Fidelity Investments, Vanguard and Bank of America generally say that the answer is yes — RMDs from Roths inherited by non-spouses are required. But some banks, wealth advisors and retirement experts say the answer is no.
“If you inherited a Roth IRA, then the same rules generally apply — you must take RMDs,” Fidelity says on its website. Asked if inherited Roth plans require annual distributions, Sham Ganglani, the director of wealth management experience and retirement at Fidelity, said that “yes, there is a required minimum distribution.”
Likewise, Vanguard says on its website that “Roth IRA owners don’t need to take RMDs during their lifetimes, but beneficiaries who inherit Roth IRAs must take RMDs.”
Merrill Lynch says the same of heirs to Roths: For such plans, “original account owners are not subject to RMD rules unlike traditional IRAs. (Beneficiaries are required to take distributions upon inheritance.)” its website says.
RW Baird says that “When a Roth IRA owner is alive, they do not have to take Required Minimum Distributions (RMDs). This is not the case for beneficiaries of a Roth IRA. The IRS requires distributions to be taken from the inherited Roth IRA. The one exception is a spouse beneficiary.”
Ed Slott, an accountant and retirement expert in Rockville Centre, New York, has a different take.
Beneficiaries won’t get hit with a 50% penalty for not making withdrawals in 2021 and 2022 — an unexpected move by the IRS. But questions still remain.
“Anyone who inherits a Roth IRA who’s a ‘regular’ beneficiary, like a son or daughter, in 2020 or later does not have RMDs for years one through nine,” he said. “It’s a big advantage to inherit a Roth because if you’re a beneficiary, you don’t have to take anything out until the end of year 10 as opposed to a [traditional] IRA.” That benefit allows the accounts to grow substantially in value.
What if a spouse inherits a Roth IRA? If she rolls it into her own Roth IRA, she never has to take RMDs and does not have to drain the account in 10 years, Slott said.
Likewise, Elliot Davis, an accounting and advisory firm headquartered in Greenville, South Carolina, says on its website that “Roth IRAs don’t have RMDs, so beneficiaries need only empty the accounts by the end of 10 years” and not make withdrawals in years one through nine. By “beneficiaries,” the firm meant non-spousal heirs.
And U.S. Bank says on its website that for non-spousal heirs to Roth IRAs, “a distribution is not required each year.”
Slott said that part of the confusion may come from wealth management firms making short, declarative statements about complex rules and proposals with conditions and exceptions.
“They may be answering a different question,” Slott said. “It reminds me of that old Pink Panther movie with Peter Sellers. He comes across a guy who’s walking a dog. And he says, ‘does your dog bite?’ And the guy says, ‘No, my dog doesn’t bite.’ And the dog chews his arm off and there’s blood all over the place. He says, ‘I thought you said your dog doesn’t bite!’ And the guy said, ‘That’s not my dog.'”
IRAs held $11.7 trillion in assets at the end of June 2022, according to the Investment Company Institute. For 2020, the industry group said that nearly 37 million Americans had traditional IRAs, while just over 26 million had a Roth IRA. Annual withdrawals will cut into the trillions of legacy dollars set to pass to surviving spouses and the next generation in coming decades.
The shifting, confusing and wonky language of the Treasury Department and the IRS are largely to blame for the confusion. “We’re kind of like in this limbo right now about exactly how the IRS wants to do RMDs, because what we have right now looks like it would only apply to tax-deferred accounts, not to Roths,” Adams said.
In March 2021, the agency said that annual withdrawals were required in years one through nine before an inherited account is emptied in year 10.
Then in May 2021 it said the opposite — no RMDs were required.
Last February, the IRS shocked advisors and accountants with another about-face, saying that distributions were, in fact, required for non-spousal heirs of traditional retirement accounts — but not for any heirs to Roth plans.
An IRS spokesman said Tuesday that “post-2019 deaths use the RMD rules under the SECURE Act, life expectancy or the 10-year rule,” but declined to elaborate. The spokesman also said that at least one of the agency’s webpages “needs to be updated for the SECURE Act 10-year rule.”
“There’s an enormous impact if you are able to let an inherited Roth grow tax free for 10 more years, versus if you have annual RMDs,” said Anthony Fabris, an accountant and certified financial planner at Myklebust, Horne & Fies Financial Group in Mequon, Wisconsin. “It’s much more attractive if you’re able to just let it sit for 10 more years at 7% growth — that money would double in 10 years.” His take: “I do not believe there is an annual RMD on inherited Roth accounts.”
This story has been updated with comments from the IRS.
Anil Vazirani is president of Secured Financial Solutions, independent insurance advisor investment advisor rep with a fiduciary obligation and in the financial services industry since 1994. A+ rating with the Better Business Bureau for over a decade and a half, members in good standing with the National Association of Insurance and Financial Advisors.
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