FREE NEWSLETTER
EVERY JANUARY, if you own an IRA and money must come out of it that year, your custodian writes to you. The letter gives you the amount or offers to work it out. We barely read it, but it is doing more than we notice.
Most people never miss a required distribution, and the reason is not diligence. It is that somebody tells them.
Inherited IRAs are different. The IRS notice that creates the requirement says reporting is not required for the IRAs of deceased owners, and an inherited IRA is exactly that. No letter is owed to the person who inherits, and in many cases none arrives.
When nobody tells us anything needs doing, we assume nothing does. Here that assumption is expensive.
The question behind the question
Everyone remembers the 10-year rule. It answers one question: when does the account have to be empty? It does not answer the one that costs money: does something have to come out this year?
That turns on a fact about the person who died. Had they reached the age at which their own distributions had to begin? It is 72 for anyone born before 1951, 73 for those born between 1951 and 1959, and 75 for anyone born in 1960 or later.
Take the common case, an adult child inheriting a traditional IRA. If the parent died before reaching that age, nothing has to come out until the account is emptied at the end of year 10. If the parent died on or after it, a required minimum distribution, or RMD, is due every year in the meantime, and the account still has to be empty at the end of year 10.
That second case is the one people get wrong. The 10-year rule is widely remembered as permission to leave the money alone until year 10, and for a great many people who inherit, it is not.
Other beneficiaries have their own timing, among them a disabled or chronically ill beneficiary, a minor child, and anyone less than 10 years younger than the person who died. Inherited Roth IRAs differ again, and a spouse has choices nobody else has. All of it sits in the SECURE Act and its 2022 successor, which is what to search.
Take too little and the shortfall carries an excise tax of 25% of what should have come out, or 10% if you correct it promptly. That is on top of the income tax you owe when the money finally comes out.
And there are two ways to trigger it. Taking too little in a year is one. The other is reaching the end of year 10 with money still in the account, because whatever is left on that date is treated as a shortfall too.
What four quiet years cost
A widow turns 76 the year after her husband dies. He was 78, well past the age his own distributions had to begin. She has Social Security of $36,000, a pension of $24,000, and his IRA, still titled as an inherited account, holding $480,000.
She does not need the money, no reminder arrives from the custodian, and so she takes none of it for four years while the account grows at 5%.
Because he had already passed that age, and because she left the account titled as inherited, she owes a distribution in every one of those years.
At 76 she should have taken $34,043. At 77, $37,895. At 78, $42,000. At 79, $46,694, by which point the untouched balance has grown to $555,660.
She has missed $160,631 of required distributions. At 25%, the excise tax on that is $40,158. Corrected in time it would be $16,063.
Now the part I expected to be worse than it is. When she corrects, all four distributions come out in a single year, and I assumed that bunching would be the quiet disaster.
Spread across four years, the distributions cost her $37,566 in federal income tax. Bunched into one, $38,783. The difference is $1,216. If you have been told the danger of a missed distribution is the bracket you land in when you fix it, check that against your own numbers before believing it.
The bigger surprise came from Medicare.
The surcharge nobody sees
Take the distributions on time and her Medicare surcharge is zero in all four years. Bunch them into a single return and it is $6,355.
That bill does not arrive with the tax. Medicare sets your Part B and Part D premiums from your income two years earlier, so the surcharge turns up long after the correction has been filed and forgotten, attached to something that does not look like a tax at all.
Add it up. Four quiet years cost her about $47,700 she need not have spent: $40,158 of excise tax, $1,216 of extra income tax from the bunching, and $6,355 of Medicare surcharge. The $37,566 of income tax on the distributions themselves was never avoidable and was never the problem.
In none of those four years did anyone write to her. The first letter came from the IRS, years late, and fixing it by then meant amended returns and a Form 5329 for every year.
What actually prevents it
Not vigilance. Nobody is vigilant about a rule they have not heard of, and the custodian was never obliged to tell you.
If you have already inherited, two facts settle almost all of it. The year the person died, and whether by then they had reached the age their own distributions had to begin.
Your custodian can tell you how the account is titled. Nobody but you is going to find that second date.
And if you are reading this married, with both of you alive and nothing yet owed, you are in the only position from which this is easy. Work out the year each of you reaches that age. For whichever of you dies first, that is the year deciding whether the survivor owes a distribution the year after the death.
Write both years down, with a line saying why they matter, and put them with your trust, your will and the beneficiary designations, where the survivor will actually come across them.
The account will not remind anyone that a clock started. The only reliable reminder is the one you write down before you need it.
A note of thanks
The shape of this article came from William Perry, who spent his working years preparing returns and described in a comment thread how these cases reach a preparer. His account of the letter arriving to the widow years later convinced me the annual question deserved a piece of its own.
________________________________________________________________________________
John Urban is the founder of RetireSmartIRA, a retirement tax-planning app. Earlier, he founded GT Nexus, a supply-chain software company acquired by Infor in 2015. He lives in Northern California with his wife, Kathy, and enjoys time with family, travel, reading, Bay Area sports, and the occasional deep dive into the fine print of the tax code.
Another informative and well written article. Thanks John.
I know that my broker does not automatically calculate or notify beneficiaries of an inherited IRA about Required Minimum Distributions (RMDs) by default in a timely manner.
I would, however, further note that brokers are required to issue a form 5498 which not only shows the fair market value for a active traditional IRA with a year end balance the form also reports any IRA contributions or rollovers made, and when the named IRA owner at 12/31 has reached their RMD age the form also reports the required minimum distribution (RMD) information (such as whether an RMD is required and the calculated amount for that particular IRA). If a IRA distribution had been taken the broker would have also previously issued a form 1099-R.
There are two additional procedural problems with the 5498 forms for the beneficiary. First, they are not required to be issued until May 31 following the year the RMD was required (so there may already be a late distribution if the RMD was not taken) and, second, many (or most) brokers issue the 5498 electronically so although it has technically been issued to the 12/31 owner (and sent to the IRS) it is often overlooked by the beneficiary(s) as they may not be expecting a tax form after the typical April 15 due date of the 1040 and/or the beneficiary may not even have electronic access to the account.
Additional salt in the wound is having to amend all years an RMD was not timely taken and incurring the professional fees to do so.
I hope my thoughts help.
Best, Bill
Free Newsletter
Arrives weekly.