IRS Should’ve Put an Estate Tax on Inherited Retirement Accounts

Let’s call the age shift for required minimum distributions what it is: unnecessary and costly.

Last week, the IRS issued final rules aiming to settle a long controversial issue: whether heirs who inherited retirement accounts subject to required minimum distributions had to continue drawing payments on the same schedule. This ambiguity, among others, was introduced in the SECURE and SECURE 2.0 Acts and had taxpayers confused ever since.

The rules were supposed to clear up that confusion by explicitly stating that beneficiaries of individuals who started making required distributions must continue those distributions. But in doing so, they introduce even more complexity and confusion.

Instead of ad-hoc adjustments to RMDs, the agency should have abandoned mandatory distributions and placed a simple additional 40% tax on assets that remain in retirement accounts after a person dies. This could encourage pre-retirement contributions and post-retirement withdrawals without getting in the weeds of legislating retirement ages.

Mandatory withdrawals begin at different ages for people born in different years, reflecting changing retirement practices across generations. The revisions, effective in September, extend the age when account holders must begin withdrawing funds. The policy seems to encourage workers to save for retirement while allowing older workers to keep saving while they work into later life.

But evidence shows that changing RMD timing doesn’t motivate saving. This means the revisions allow workers of retirement age to keep their retirement accounts outside of the income tax base with no discernible corresponding benefit.

Benefits vs. Dodges

RMDs balance the income tax advantage of retirement accounts with ensuring that funds eventually are taxed as income during the account holder’s lifetime. They also prevent people from using their retirement accounts as tools for intergenerational wealth transfers.

Mandating withdrawals during the account holder’s lifetime is supposed to encourage consumption and ensure that at least some part of a retiree’s tax-advantaged savings are subject to tax in their lifetime. Retirement accounts aren’t designed to be tax-free inheritance vehicles—they provide upfront advantages to workers who are able to save part of their pre-tax income until withdrawn and then are taxed years or decades later.

There is a delicate policy balance between providing tax benefits to encourage working people to save for retirement and turning retirement accounts into intergenerational tax dodges for the wealthy. Such accounts generally are subject to estate taxes, but there’s a difference between regular income and money that is contributed to a 401(k) account.

Let’s imagine an individual earns $200 and that half is taxed as income and the other half goes into a 401(k). The taxpayer would pay income tax on the former $100, but the other $100 wouldn’t be taxed until it’s withdrawn.

When the taxpayer dies, both amounts could be subject to state and federal estate taxes, but only the former would be subject to both income and estate taxes. A retirement account that doesn’t have RMDs could become an attractive tax avoidance vehicle for high-income earners.

Before the SECURE 2.0 Act, account owners who failed to make timely withdrawals were subject to a 50% excise tax on the amount not withdrawn. SECURE 2.0 dropped this rate to 25%, or 10% if the shortfall is corrected within two years.

A taxpayer who wants to use a retirement account as a wealth transfer could be motivated to play the long game: Pay the excise tax, correct the shortfall within the 24-month window, and begin the process again. The result would be to pay successive levies of a 10% tax every two years until death, rather than making withdrawals and incurring the full cost of the income tax.

The IRS’s final rules moved the mandatory RMD withdrawal age for the youngest retirees, those born after the first day of 1960, to age 75. This reflects the trend of individuals retiring later and permits workers to leave funds in their retirement accounts longer, allowing for both appreciation and kicking the tax bill further down the road. This may have the unintended effect of causing more retirement savings to transfer to heirs untouched by income tax.

This practice is reflected by IRS guidelines that allow beneficiaries to keep funds in inherited retirement accounts for up to 10 years after the account holder’s death. Clearly, some retirement accounts are already being used as inheritance vehicles—moving the RMD withdrawal age will only exacerbate this issue.

Alternative Solution

Moving the age that RMDs must begin historically hasn’t changed worker or retiree behavior. It’s only changed the degree to which retirement accounts are seen as useful tools for intergenerational wealth transfers. Delaying the age of the first withdrawal decreases the total amount of the retirement account that will be subject to income tax.

An additional estate tax on remaining assets in retirement accounts that would have been subject to RMDs could better achieve the policy’s goals. It would also avoid ambiguities that come with complex policy drafting—such as the current oversight that leaves individuals born between Jan. 2, 1959, and the end of 1959 as being subject to initial mandatory withdrawals at both age 73 and 75.

Such a tax would target intergenerational wealth transfer by imposing a tax burden on those untouched retirement funds, encouraging account holders to withdraw and make use of the assets during their lifetime. The new tax would need to be set at a higher rate than the highest individual income tax bracket, 37%, to properly incentivize retirement account holders.

A 40% additional tax on retirement accounts at the time of death would be simpler than attempting to key RMDs to the ever-shifting average retirement age. Account holders with intergenerational wealth transfer ambitions would be motivated to take withdrawals and use their gift tax exclusion to make transfers to family members, where possible.

Even those who have exhausted their gift tax exclusion would be persuaded by tax savings inherent in making a withdrawal, paying income tax on the amount, and removing the withdrawn amount from the new retirement account estate tax. All other individuals reaching retirement age would be free to make withdrawals as their economic situations dictate.

Calibrating the Policy

Unlike RMDs, which only allow the age to be raised or lowered, a retirement account estate tax would have numerous points of adjustment. If well-designed and calibrated, such a system could have clear guidelines and a simple process with a straightforward method for calculating taxes due.

Its structure could set specific thresholds and rates, applying a given rate only to the portion of a retirement account that exceeds a certain threshold—and ensuring smaller accounts aren’t unduly burdened. This would make the policy more progressive.

The new IRS rules extending the age for RMDs fail to address the core issue of ensuring that retirement accounts are used for their intended purpose. An estate tax on remaining retirement account assets at death would more effectively encourage withdrawals during the lifetime of the account holder, fulfill policy goals of RMDs, and enhance the fairness of the tax system.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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