If you have a tax-favored retirement account, you generally must take required minimum distributions (RMDs) each year after you reach the “magic” age. If you don’t take RMDs, you’ll be hit with an expensive federal tax penalty, unless an exception applies. (See “Which Plans Are Affected by the RMD Rules?” at right.) The age that the RMDs kick in has been a moving target, thanks to recent laws.
Which Plans Are Affected by the RMD Rules?
The required minimum distribution (RMD) rules apply to all employer-sponsored retirement plans, including:
In addition, the rules cover traditional IRAs and IRA-based plans, such as SEPs, SARSEPs and SIMPLE-IRAs. But there are exceptions in certain limited circumstances. You’re also exposed to the RMD rules if you inherit a tax-favored retirement account.
Except for RMDS that meet the definition of tax-free qualified Roth IRA withdrawals, RMDs will trigger a federal income tax bill and maybe a state income tax hit, too. However, under a favorable exception, Roth IRAs set up in your name are exempt from the RMD rules while you’re alive. But if you inherit a Roth account, the RMD rules come into play.
Here’s a refresher on how the RMD rules work, along with an update on a favorable development from the IRS.
Changes to the RMD Start Date
The Setting Every Community Up for Retirement Enhancement (SECURE) Act became law in 2019. It brought numerous changes to the tax rules for retirement savings. Under the SECURE Act, you generally had to start taking RMDs for the calendar year during which you turned 72 (up from 70½ under prior law). However, as under prior law, you have the option of postponing your initial RMD until April 1 of the year following the year you turned 72.
In late 2022, Congress passed SECURE 2.0. This sequel to the original SECURE Act increases the starting age for RMDs to 73 for account owners who turn 72 in 2023 through 2032. (Starting in 2033, the magic age will increase to 75.)
So, if you turn 72 in 2023, you’ll be 73 in 2024, and your initial RMD will be for calendar year 2024. You must take that initial RMD by no later than April 1, 2025, or face a possible IRS penalty charge. Then you must take RMDs for calendar year 2025 and beyond by no later than December 31 of each year to avoid the penalty for failure to follow the RMD rules. However, thanks to SECURE 2.0, people who turn 72 in 2023 don’t have to take an RMD for 2023.
The later RMD starting age rule in SECURE 2.0 doesn’t affect you if you turned 72 before 2023. For instance, if you turned 72 in 2022, you must have taken your initial RMD for calendar year 2022 by no later than April 1, 2023, or face a possible penalty charge. You must take your second RMD for calendar year 2023 by December 31, 2023, or face a possible penalty charge. The December 31 deadline applies for all subsequent years.
Reduced Penalty for Failure to Take RMDs
Before SECURE 2.0, if you failed to take your RMD for the calendar year in question, the IRS could impose a painful 50% penalty on the shortfall. That’s the difference between the RMD amount for the year and the total withdrawals you took during that year, if any.
Good news: SECURE 2.0 generally reduces the penalty for failure to take RMDs from 50% to 25%. And if the failure to take an RMD is corrected within a correction window, the penalty is reduced from 25% to 10%. Your tax advisor can explain how the correction window works. This favorable change is effective for 2023 and beyond.
10-Year Account Liquidation Rule
The original SECURE Act also requires most non-spouse IRA and retirement plan beneficiaries to empty inherited accounts within 10 years after the account owner’s death. This is an unfavorable change for inherited accounts with substantial balances.
Before the original SECURE Act, the RMD rules allowed you to gradually drain an inherited IRA over your IRS-defined life expectancy. For example, say you inherited your grandfather’s $750,000 Roth IRA when you were 40 years old. The current IRS life expectancy table says you have 45.7 years to live. Before the original SECURE Act, you could take annual RMDs from the inherited account by dividing the account balance as of the end of the previous year by your remaining life expectancy as of the end of the current year. So, your first RMD would equal the account balance as of the previous year end divided by 45.7, which would amount to only 2.19% of the balance. Your second RMD would equal the account balance as of the end of the following year divided by 44.8, which translates to only 2.23% of the balance. That formula would apply until you emptied the inherited Roth account.
The old rules — those in place prior to the original SECURE Act — allowed you to keep the inherited account open for many years and reap the tax advantages for those many years (depending on your age). This was particularly advantageous for inherited Roth IRAs, because the income from those accounts can grow and be withdrawn federal-income-tax-free.
The SECURE Act’s unfavorable 10-year account liquidation rule is generally effective for RMDs taken from accounts whose owners die after 2019. The RMD rules for accounts inherited from owners who died before 2020 are unchanged. However, there is some relief as described below.
Exceptions to the Unfavorable 10-Year Account Liquidation Rule
The original SECURE Act’s unfavorable RMD change won’t affect account owners who drain their accounts during their retirement years and leave no balances to their heirs. And beneficiaries who want to quickly drain inherited accounts will also be unaffected. The change will only affect certain beneficiaries who want to keep inherited accounts open for as long as possible to reap the tax advantages.
The change also won’t affect accounts inherited by an “eligible designated beneficiary.” An eligible designated beneficiary is:
- The surviving spouse of the deceased account owner,
- A minor child of the deceased account owner,
- A beneficiary who’s no more than 10 years younger than the deceased account owner, or
- A chronically ill individual.
Under the exception for eligible designated beneficiaries, RMDs from the inherited account can generally be taken over the IRS-designated life expectancy of the eligible designated beneficiary, beginning with the year following the year of the account owner’s death. For these fortunate individuals, the RMD rules are unchanged from the rules that were in effect before the original SECURE Act.
Following the death of an eligible designated beneficiary, the account balance must be distributed within 10 years to avoid a penalty for failure to follow the RMD rules. When an account owner’s child reaches the age of majority under applicable state law, the account balance must be distributed within 10 years after that date to avoid a penalty for failure to follow the RMD rules.
According to IRS proposed regulations issued in 2022, beneficiaries who are subject to the SECURE Act’s 10-year account liquidation rule must take annual RMDs during the 10-year period. However, this interpretation didn’t seem to be justified by the statutory language, which simply says the inherited account must be drained within 10 years to avoid a penalty for failure to follow the RMD rules. Therefore, some beneficiaries of account owners who died in 2020 didn’t take RMDs in 2021 or 2022 — and they may not take them in 2023.
Advocates for these beneficiaries asserted that if yet-to-be-issued final RMD regulations adopt the unfavorable interpretation of the 10-year rule set forth in the proposed regulations, the IRS should provide transition relief for those who failed to take RMDs in 2021 and 2022. In Notice 2022-53, the IRS granted such relief by stating that the penalty for failure to follow the RMD rules wouldn’t be assessed against beneficiaries subject to the 10-year rule who didn’t take RMDs in 2021 and 2022 based on their position that they weren’t statutorily required to do so.
In recently issued Notice 2023-54, the IRS extended this relief to beneficiaries subject to the 10-year rule who don’t take RMDs in 2023 — also based on their position that they aren’t required to do so. Notice 2023-54 also states that the IRS intends to issue new final RMD regulations that won’t take effect until the 2024 calendar year at the earliest.
Good News, Bad News
The SECURE Act and SECURE 2.0 generally were good news for retirement savers. But the SECURE Act included an unfavorable provision for retirement account beneficiaries in the form of the 10-year account liquidation rule. However, exactly how that rule is supposed to work is still to be determined, pending yet-to-be-released IRS final regulations. For more information about RMDs, contact your tax advisor.