When Beneficiaries Run Into the 5-year Rule

 Three questions can turn an ordinary inherited IRA into a bigger tax problem.

Who was named as beneficiary? Had the IRA owner already started required minimum distributions? And was the beneficiary a real person, a trust, an estate, or simply left blank?

These primary questions determine whether a family has ten years or five to drain an inherited IRA, or in some cases a different payout schedule altogether.

Since the SECURE Act, most people have heard about the “10-year rule.” The old stretch IRA was largely eliminated for most non-spouse beneficiaries. Children, grandchildren, nieces, nephews, and many other individual heirs generally must empty the inherited IRA by the end of the tenth year after death. Some beneficiaries — surviving spouses and other special classes of beneficiaries, and beneficiaries not more than ten years younger than the decedent — may receive more favorable treatment.

That is where the confusion begins. Many families now assume the 10-year rule swallowed everything. The 5-year rule still matters when there is no “designated beneficiary.” Most often, that means the IRA was left to the estate, the beneficiary form was blank, the named beneficiary died first and no contingent beneficiary was listed, or a trust was named but failed to qualify as a see-through trust. If the IRA owner dies before the required beginning date, that can force the entire account out by the end of the fifth year after death. For a Roth IRA, because there are no lifetime RMDs for the owner, this issue can also appear when the beneficiary is an estate or non-qualifying trust.

This is not a small paperwork problem. It forces distributions from a traditional IRA loaded with deferred ordinary income. Compress ten years into five, or lose the ability to plan distributions across multiple tax years, and the inheritance might be pushed into higher brackets at exactly the wrong time, or in a down cycle for the markets.

Beneficiary forms usually beat the will. A beautifully drafted will might say one thing, while the IRA custodian pays according to the beneficiary form on file. In Kennedy v. DuPont, a retirement plan paid an ex-spouse because the plan documents and beneficiary designation still controlled.

The checklist is short but important: confirm the primary and contingent beneficiaries, avoid accidentally naming the estate, review any trust with an attorney who understands IRA distribution rules, determine whether the owner died before or after the required beginning date, and never assume the 10-year rule is the only rule left.