Current Inherited Retirement Account Rules
Upon the death of the owner of an IRA or qualified plan, the following are potential outcomes in terms of potential inherited retirement account distribution rules:
- Spousal Rollover
- Required Minimum Distributions (“RMDs”)
- 10 Year Rule
- 10 Year Rule with RMDs
- 5 Year Rule
Woah! That there are so many possible outcomes, which require significant analysis to determine, is absolutely ridiculous and an unnecessary burden on American taxpayers.
Proposed Inherited Retirement Account Reform
I propose that the current voluminous, complicated inherited retirement account rules be scrapped. They should be replaced by the following simple rules, all effective January 1, 2025 unless otherwise noted.
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At the decedent spouse’s death, any retirement account left to a spouse becomes the surviving spouse’s retirement account in the surviving spouse’s own name automatically and immediately upon death.
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All other beneficiaries inherit an inherited retirement account which must be emptied within 10 full years following the owner’s death with no RMDs in years 1 through 9.
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The death of a spouse entitles the surviving spouse to a permanent exception to the Section 72(t) 10 percent early withdrawal penalty with respect to distributions from any retirement account.
- This applies even if the widow/widower remarries.
- For fairness and simplicity, this applies even if the spouse died prior to 2025.
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Any inherited retirement account a widow or widower treats as an inherited retirement account instead of a spousal rollover account as of the end of 2024 automatically becomes the surviving spouse’s own retirement account in their own name as of January 1, 2025.
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The death of the beneficiary of an inherited retirement account does not change the clock. Successor beneficiaries must empty the inherited retirement account by the end of the 10th full calendar year following the original owner’s death.
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Existing inherited retirement accounts (as of the end of 2024) are no longer subject to both the 10 year rule and RMDs. For 2025 and beyond, such accounts are subject to only the 10 year rule.
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For fairness and simplicity, any retirement account inherited prior to 2025 subject to a 5 year rule will switch to the 10 year rule (measured as of the owner’s date of death).
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Reset Day for Inherited Retirement Accounts Subject to an RMD in 2025: If the original owner died in 2024 or earlier and the inherited retirement account is subject to only an RMD in the year 2025 (under any of the old rules), the inherited account will become subject to the 10 year rule, and no longer be subject to RMDs (both as of 2026), as if the original owner died on December 31, 2025.
- The 2025 New Year’s Eve Reset Day applies to both beneficiaries and successor beneficiaries, including those who become successor beneficiaries during 2025.
Simplification
After my proposed reform, there will be two and only two potential treatments for an inherited retirement account: spousal rollovers for spouses and the 10 year rule for everyone else. Note: It takes 8 rules to get to a 2 rule system because in order to get to a 2 rule system there needs to be rules to account for the transition from a very complex system to an understandable system.
Replacing the existing rules with the above 2 rule system would significantly reduce the amount of federal regulations and reduce complexity. Congress stumbled into a great inherited retirement account rule in the SECURE Act: the 10 year rule. It’s time to make that the rule for all inherited retirement accounts except spousal rollovers.
Rules 4, 7, and 8 are simplification and consistency measures. They logically transition the inherited retirement accounts rules to a single, uniform system with only two outcomes: a spousal rollover or the 10 year rule.
Rapid Transition
I propose a rapid, though not overnight, transition to a uniform system. Assuming a bill is passed in early to mid-2025, 2025 can be a transition year and then by New Year’s Day 2026 all inherited retirement accounts would be on the new system, meaning all inherited retirement accounts, regardless of when inherited, would be subject to only one of two rules as of New Year’s Day 2026.
Protecting Young Widows and Widowers
Rule 3 is needed to avoid reform harming pre-age 59 ½ widows and widowers. Under today’s rules, surviving spouses can elect to treat a spouse’s retirement account as an “inherited” account instead of doing a spousal rollover. That inherited treatment avoids the 10 percent early withdrawal penalty on pre-age 59 ½ distributions.
If pre-age 59 ½ widows/widowers must do a spousal rollover (as I propose), they would be subject to the 10 percent early withdrawal penalty if they took taxable distributions prior to their 59 1/2th birthday. To avoid that outcome, why not make becoming a widow/widower an automatic, permanent exception to the 10 percent early withdrawal penalty?
Transition Entirely to a New Uniform System
Reform should clean the slate of complexity. Without rules 4, 7, and 8, there would be separate systems of rules for retirement accounts inherited prior to 2025 and those inherited in 2025 or later. There’s no need for two separate systems of rules. These three rules make the rules simple for all inherited retirement accounts going forward.
A Small Net Tax Increase
Rule 8 is a modest tax increase, mostly falling on the wealthiest Americans. Considering the hope that 2025 will bring some popular tax cuts, such as eliminating taxes on tips and Social Security, it is good to have at least some logical tax increases in 2025 that would not significantly impact ordinary Americans. Note also that rules 2 and 5 are also likely to be small tax increases while rules 3 and 7 are likely to be small tax cuts.
Regardless of the likely very modest net tax effect, the simplicity brought by this new system would greatly benefit the administration of the tax rules and ordinary Americans.