5 Facts About the Beneficiary 5-Year Rule for IRAs and Employer Plans

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The 5-year rule for beneficiary distributions from inherited retirement accounts is optional in some cases and required in others. Knowing when it applies can allow an advisor to help clients mitigate unfavorable limitations.

When it comes to the options that are available to beneficiaries of retirement accounts, there is a widespread misunderstanding of the applicable rules that has led many beneficiaries to believe that the 5-year rule could apply regardless of the age at which the retirement account owner (participant) died. This misunderstanding often leads to missed opportunities and avoidable excess accumulation penalties.

As an advisor, you can help clients understand their options and work with them to avoid the 5-year rule, if needed. This starts with identifying the participant’s required beginning date (RBD), determining whether death occurred before the RBD, and determining when the 5-year rule might apply.

‘Required beginning date’ defined

The RBD is the deadline by which participants must start taking required minimum distributions (RMD) from their retirement accounts.

For IRAs, the RBD is April 1 of the year that follows the year in which the IRA owner reaches age 70½. This applies to traditional IRAs, SEP IRAs and SIMPLE IRAs.

For employer-sponsored retirement plans (such as pension, 401(k), 403(b) and governmental 457(b) plans—including designated Roth accounts such as Roth 401(k)s, the RBD is April 1 of the year that follows the year in which the participant reaches age 70½. But, for participants who are still employed by the plan sponsor (employer) as of this date, the employer can defer the RBD until April 1 of the year that follows the year in which the participant terminates employment with the employer. IRC § 401(a)(9)(C); Treas. Reg. § 1.401(a)(9)-2, Q&A 2

Roth IRA owners are not subject to required minimum distributions (RMD), therefore, there is no RBD for Roth IRAs. IRC § 408A(c)(5)

Being able to identify the participant’s RBD is a critical component of distribution planning for beneficiaries, because the distribution options that apply to the beneficiary depends on the relationship between the beneficiary and the decedent, and whether the participant died before the RBD. The following is a high-level summary of these options:

Source: Denise Appleby

The 5-Year Rule

Under the 5-year rule, distributions are optional until December 31 of the fifth year, that follows the year in which the participant dies—at which time the entire inherited amount must be withdrawn (distributed) from the retirement account. Contrast this with the life-expectancy rule, which permits eligible beneficiaries to take distributions over an applicable life expectancy (see table above)—taking no less than the beneficiary RMD amount each year. IRC § 401(a)(9)(B)(ii)

The default provision

When a participant dies before the RBD, the distribution options are the 5-year rule and the life expectancy rule. Under the life-expectancy rule, distributions must begin over the single life expectancy of the beneficiary, by December 31 of the year that follows the year in which the participant dies, and continue for every subsequent year. Please note: For a spouse beneficiary, life expectancy distributions need not begin until the later of December 31 of the year that follows the year of death or the year in which the participant would have reached age 70½.

The life expectancy rule is the default option under the RMD regulations.

However, an IRA or plan agreement can provide that the 5-year rule is the default option. Treas. Reg. § 1.401(a)(9)-3, Q&A-4(b).

The following are 5 key facts about the 5-year rule, which can be used to help effectively implement beneficiary distribution strategies.

1. The 5-year rule applies only if the participant dies before the required beginning date

The 5-year rule is an option, only if the participant dies before the RBD. Cite Treas. Reg. §1.401(a)(9)-3.

If the participant dies on or after the RBD, then the 5-year rule does not apply. Cite Treas. Reg. 1.401(a)(9)-5, Q&A 5.

2. It is always an option for Roth IRAs

There is no RMD for Roth IRA owners and therefore no RBD. Therefore, the rules that apply to the beneficiary of a traditional IRA when the owner dies before the RBD always apply to a Roth IRA beneficiary, regardless of the age at which the Roth IRA owner dies. As such, the 5-year rule is always an option for a Roth IRA beneficiary.

3. It is the only option for a non-designated beneficiary

If the participant dies before the RBD, and the retirement account does not have a designated beneficiary, the only option is the 5-year rule.

The beneficiaries of a retirement account are not “designated beneficiaries” if, as of September 30 of the year that follows the year in which the participant dies, there are any remaining beneficiaries that are nonpersons or nonqualified trusts on the account. (See “IRA Beneficiary Audit: Help Clients’ Beneficiaries Maximize Their Benefits.”)

4. It can be used to avoid the excess accumulation penalty for missed life-expectancy RMDs

If the beneficiary is subject to the life-expectancy option, beneficiary RMDs must be taken every year, starting with the year that follows the year in which the participant dies. If an RMD is not taken for a year, the beneficiary is subject to a 50% excess accumulation penalty for that RMD amount.

That penalty is automatically waived, if it is incurred before the end of the 5-year period that applies under the 5-year rule, and the beneficiary switches from the life-expectancy rule to the 5-year rule.

5. It can be overridden

If an IRA or plan agreement provides that the 5-year rule is the default provision, the beneficiary may override that limitation if desired. This override is accomplished by:

• Making an election, if permitted under the IRA or employer plan,
• If it’s an IRA, transferring the assets to an inherited IRA that permits the life expectancy option. A rollover is not an option in this case. And
• For an employer-sponsored retirement plan, move the assets—via a direct rollover—to an inherited IRA that permits the life-expectancy option.

The deadline for the override is December 31, of the year that follows the year in which the participant dies.

Timing is critical

When consulting with a beneficiary about an inherited retirement account, determining the distribution options available is a key part of the process. If the participant died before the RBD, the available options should be reviewed timely, so that any required election can be made by the beneficiary by any applicable deadline. For those who find themselves subject to the 5-year rule— which is often the case for employer-sponsored retirement plans when the participant dies before the RBD—the beneficiary should take overriding action by the deadline (see above), if the objective is to use the life-expectancy option.