By Oscar Casas, CFP®, CRPC®, MPAS®, ABFP℠
Inheriting an IRA can leave you with a valuable asset and a set of rules you may have never encountered before. What you can do with the account, when you may need to take distributions, and how those withdrawals are taxed can depend on your relationship to the original owner and the type of IRA you inherited.
It helps to understand your inherited IRA options before moving or withdrawing money so you can avoid decisions that are difficult to undo. Here’s what beneficiaries should know before making their next move.
Spousal Inheritance
If you inherit an IRA from your spouse, you can simply roll over the money into your own like-kind IRA account (traditional IRA or Roth IRA). In such cases, there is no taxable event and your former spouse’s money is thereafter treated as your own. All the same rules can apply as if it was always your money, including required minimum distributions (RMDs).
Be aware, however, that since your IRA may now be much larger after the rollover, so may the RMDs. If you thereafter file as a single taxpayer (instead of married-filing-jointly when your spouse was alive), your tax bracket and tax liability may be greater as well.
Lump-Sum Option
An option available to all heirs, regardless of relationship, is to simply cash out the account. You can take the money in a single lump sum penalty-free. However, you may have to pay income taxes depending on whether the contributions were made pre- or post-tax. Receiving a large sum that counts as income for tax purposes may push you into a higher tax bracket.
New Inherited IRA Rules
Changes to the IRS regulations, finalized and effective July 19, 2024, could impact your inheritance. The ability to stretch out IRA distributions over time—a key tax advantage—was removed by the SECURE Act of 2019. As a result, more of the inherited funds may be lost to taxes, reducing the amount your loved one intended for you. SECURE Act 2.0 modified the new rule, but also raised the initial RMD age to 73 (increasing to 75 in 2033).
The revised 10-year rule applies to non-spousal beneficiaries of IRAs inherited after January 1, 2020. Funds must be withdrawn within 10 years of the benefactor’s death, with certain exceptions for eligible designated beneficiaries like minors, and disabled individuals.
Minor children of the account owner remain Eligible Designated Beneficiaries only until they reach the age of majority (age 21 under IRS rules). Upon turning 21, the 10-year depletion timer begins, requiring the account to be fully emptied by age 31.
For non-spouse beneficiaries inheriting an IRA where the owner died on or after their Required Beginning Date (RBD), annual RMDs in Years 1–9 are required. Note that failure to satisfy the annual RMD results in an excise tax penalty of 25% (which may be reduced to 10% if corrected in a timely manner). For IRAs where the owner died before their RBD, no mandatory RMDs during years 1-9 are required, but the account must still be depleted by year 10.
Inherited Roth IRAs are also subject to the 10-year distribution rule but don’t require annual RMDs during the first 9 years, unlike traditional IRAs. Inherited Roth IRAs must be fully distributed by year 10, but the distributions have no impact on the beneficiary’s tax situation.
Inherited IRA As a Wealth Transfer Method
IRAs aren’t required to pass to spouses at death. The account owner can designate any beneficiary that they choose. Because of this, some families use IRAs as a powerful wealth transfer method.
If an account owner knows that his or her spouse may not need the money, they can designate another relative as the beneficiary. The younger the beneficiary, the longer the money may have to grow (after the 10-year required distribution has finished and any applicable taxes paid) for the beneficiary’s future needs. Many people designate grandchildren as IRA beneficiaries so they can pass on an inheritance that can eventually continue to grow for many years.
However, under the SECURE Act, grandchildren are still non-spousal designated beneficiaries (unless disabled or chronically ill). They can no longer stretch distributions over their lifetime; they are strictly bound by the 10-year rule and must fully deplete the account within 10 years as other non-spousal beneficiaries.
Even though the “stretch” strategy is no longer available, designating grandchildren or younger heirs as a strategic multi-year distribution planning tool (e.g., spreading withdrawals across the 10 years to minimize tax bracket spikes) may still be a worthwhile strategy in the context of overall legacy and tax planning.
Understanding Your Inherited IRA Options
With these inherited IRA options, small differences in the type of account, your relationship to the original owner, and when the account was inherited can affect the rules you need to follow. The choices you make can also have tax consequences, so it helps to understand your options before taking distributions or moving money.
Are you sorting through your inherited IRA options and unsure what makes sense for your situation? We at Tranquility Path Investment Advisors can help. Schedule a no-obligation conversation or reach us at (908) 759-6322 to discuss how the account fits into your broader financial plan.
