Inheriting an IRA? Here’s What You Need to Know
Inheriting an Individual Retirement Account (IRA) can be both a financial opportunity and a challenge. On one hand, receiving a sizable inheritance can boost your financial stability, help you achieve long-term goals, and even provide a reliable income stream. On the other hand, inheriting an IRA comes with complex tax implications that differ depending on the type of IRA and your relationship to the original account holder.
Recent changes in legislation have significantly affected how inherited IRAs are managed, particularly regarding withdrawal timelines and tax responsibilities. Here’s what you need to know to maximize the benefits of your inheritance while avoiding potential financial pitfalls.
The SECURE Act & 10-Year Rule
The SECURE Act of 2019 introduced significant changes to how many beneficiaries manage inherited IRAs. Among the most impactful was the elimination of the “stretch IRA” for most non-spouse beneficiaries.
Before the SECURE Act, these heirs could extend distributions from an inherited IRA over their lifetime, allowing for prolonged tax-deferred growth and potentially reducing their tax burden. This approach was particularly advantageous for younger beneficiaries who could spread out distributions over several decades.
The SECURE Act replaced this strategy with the 10-year rule, which now applies to many beneficiaries who inherited IRAs after 2020. Under this rule, most non-spouse beneficiaries are required to fully withdraw the inherited IRA within 10 years of the original owner’s death—a change that carries significant financial planning implications.
Types of IRA Beneficiaries
When inheriting an IRA, the Internal Revenue Service (IRS) applies different rules based on your relationship to the original account owner. Understanding your beneficiary type is essential, as it dictates the regulations you must follow and the options available to you.
Spouses have the greatest flexibility as IRA beneficiaries. For instance, if you inherit an IRA from your spouse, you can roll the inherited IRA into your own IRA, which offers more favorable tax treatment and distribution rules.
Non-spouse beneficiaries, such as children, siblings, or friends of the original IRA owner, face stricter regulations. Most non-spouse beneficiaries must adhere to the 10-year rule, requiring them to withdraw the entire IRA within 10 years of the original owner’s death.
However, there’s a special category known as Eligible Designated Beneficiaries (EDBs), which includes:
- Disabled or chronically ill individuals
- Those no more than 10 years younger than the IRA owner
- Minor children of the IRA owner (until they reach the age of majority)
EDBs are exempt from the 10-year rule and can still utilize the old “stretch IRA” strategy, taking distributions over their life expectancy.
Spouse Beneficiary Rules
If you’ve inherited an IRA from a spouse, it’s important to understand your options, as each has its own benefits and drawbacks. The best choice will depend on factors like your age, financial needs, and overall retirement strategy.
One option is to roll the inherited IRA into your own IRA. This can be particularly beneficial if you’re under 59½, as it allows you to delay Required Minimum Distributions (RMDs) until you reach age 73 (as of 2023). Additionally, rolling the inherited IRA into your own account enables you to designate your own beneficiaries. However, keep in mind that if you need to access the funds before age 59½, you could face a 10% early withdrawal penalty.
Alternatively, you can keep the account as an inherited IRA. This might be the better option if you’re under 59½ and need to access the funds right away without triggering the 10% early withdrawal penalty. With this choice, you’ll be required to take RMDs based on your life expectancy, but you can delay them until your spouse would have reached age 73.
Non-Spouse Beneficiary Rules
The rules for non-spouse beneficiaries inheriting IRAs have become more intricate following the SECURE Act. The most notable change is the introduction of the 10-year rule, which applies to most non-spouse beneficiaries who inherited an IRA after January 1, 2020.
Under this rule, the entire balance of the inherited IRA must be withdrawn by the end of the tenth year after the original owner’s death. While you aren’t required to take distributions every year, the account must be fully depleted within that 10-year period.
There is, however, an important exception: if the original owner had already begun taking Required Minimum Distributions (RMDs), the beneficiary must continue taking annual RMDs based on their own life expectancy, in addition to emptying the account within the 10-year timeframe.
It’s also essential to recognize that certain exceptions exist for Eligible Designated Beneficiaries (EDBs). EDBs can still utilize the “stretch IRA” strategy, allowing them to take distributions over their life expectancy. This can help reduce the tax burden and enable continued growth of the inherited funds.
Understanding these rules is crucial for effective tax planning and avoiding penalties. The 10-year rule, in particular, can lead to larger taxable distributions, making it important to carefully plan your withdrawals to minimize tax impacts while complying with the regulations.
Required Minimum Distributions (RMDs) for Inherited IRAs
The IRS has recently clarified the rules around Required Minimum Distributions (RMDs) for inherited IRAs, helping to resolve some of the confusion that followed the SECURE Act.
For most non-spouse beneficiaries who inherit an IRA from someone who had already begun taking RMDs, the IRS now mandates annual withdrawals. These RMDs must start in the year following the original owner’s death, with the first distribution due by December 31st of that year.
To calculate RMDs for inherited IRAs, you can refer to Table I (Single Life Expectancy) in IRS Publication 590-B. Alternatively, online calculators are available to assist with these calculations.
Failing to take RMDs on time can result in significant penalties. The current penalty is 25% of the amount that should have been withdrawn. However, if you correct the oversight promptly—generally within two years—the penalty may be reduced to 10%.
It’s important to note that these RMD requirements apply in addition to the 10-year rule for depleting the account. This means you must take annual RMDs during years 1-9 and then withdraw any remaining balance in the 10th year.
Understanding the Tax Implications of Inherited IRAs
The tax implications of inheriting an IRA vary greatly depending on whether it’s a traditional or Roth IRA. Understanding these differences is key to effectively managing your tax liability.
For traditional IRAs, withdrawals are generally taxed as ordinary income in the year they are taken. This means that inheriting a sizable traditional IRA could potentially push you into a higher tax bracket, especially if you’re required to deplete the account within 10 years.
In contrast, Roth IRAs offer more favorable tax treatment. Withdrawals from inherited Roth IRAs are typically tax-free, provided the account has been open for at least five years.
To help manage your tax liability, consider the following strategies:
- Spread out withdrawals over the allowed timeframe to avoid significant increases in taxable income.
- Coordinate IRA withdrawals with your other income sources to manage your overall tax bracket.
- Consider taking larger distributions in years when your income is lower or when you have higher deductions.
- If you’ve inherited both traditional and Roth IRAs, plan your withdrawals strategically, considering your current and future tax situations.
Consulting with a financial planner or tax professional is a wise step to develop a personalized strategy that aligns with your specific financial circumstances and goals.
TrueNorth Wealth Is Here to Help
Managing an inherited IRA demands thoughtful planning and strategy. By understanding the specific rules that apply to your situation and aligning them with your financial goals, you can take steps to maximize the value of your inheritance while avoiding costly mistakes.
Navigating the complexities of inheriting an IRA can be challenging, but you don’t have to do it alone. At TrueNorth Wealth, our team of fiduciary CFP® professionals is here to offer personalized advice and support. We’ll help you make informed decisions that honor your values and goals, ensuring you get the most out of your inheritance.
TrueNorth Wealth is among the top Wealth Management firms in Utah and Idaho, with offices in Salt Lake City, Logan, St. George, and Boise. At TrueNorth Wealth, we focus on helping our clients build long-term wealth while maximizing the enjoyment they receive from their money. We do this by pairing our clients with a dedicated CFP® professional backed by an incredible team.
