Proposal Would Dramatically Change Rules for Inherited IRAs

On February 7th, Max Baucus, the Senate Finance Committee Chairman, proposed dramatic changes to the distribution rules for beneficiaries of inherited IRAs, 401(k)'s, and other qualified plan accounts (all termed "IRAs" in this post), for deaths after 2012.  The proposal raises $4.6 billion over 10 years and is part of a highway funding bill.  The change would require beneficiaries to completely distribute the inherited accounts within five years.  Exceptions would be provided for certain beneficiaries:  disabled or chronically ill individuals, surviving spouses, children who had not attained the age of majority, and beneficiaries who are not more than 10 years younger than the deceased account owner.  Once these beneficiaries die, the five-year rule applies to their beneficiaries.  Furthermore, when a beneficiary-child reaches the age of majority, the five-year rule commences.  Senator Baucus justifies his proposal by stating that IRAs are intended for retirement, but some taxpayers are using them to give tax-free benefits to second, third, and maybe fourth generations.  He further stated that if this proposal doesn't pass now, perhaps it will as part of tax reform.

Current rules permit beneficiaries to stretch-out distributions from inherited IRAs over their life expectancies.  The younger the beneficiary, the longer the stretch-out period.  In the early years, the IRA can continue to grow in value as the required distribution amounts will generally be less than the IRA earnings.  Distributions from traditional IRAs are subject to income tax.  A 50% penalty applies to any shortfall in the required minimum distribution amount.  Accelerating the required distribution amounts eliminates the financial benefits of compounding IRA earnings on a tax-deferred basis.  The proposed change will have a major detrimental financial impact upon families that have used retirement accounts to save for the future.  Larger required distributions will likely cause the beneficiary to pay income tax on the benefits at a higher tax rate, and will tempt beneficiaries to spend their inheritances instead of preserving the IRA benefits for their own retirements.  Furthermore, once the assets are outside of the IRA, the beneficiary loses whatever asset protection benefits were afforded by the IRA.

The proposed change goes even further and can apply to IRA accounts of owners who have died or will die before 2013.  Once the primary IRA beneficiary (who may use the current stretch-out rules) dies, those who succeed to the primary beneficiary's benefits will be subject to the new five-year payout rule!

Many commentators do not believe this proposal will become law at this time.  If it does become law, proactive planning will be necessary to reduce the resulting financial loss on families.  This proposal will upend the financial planning of many families, and seems to be a short-sighted grab for tax revenue to fund one-time government expenditures.