A client booked a meeting with me last week to discuss a question about an inherited IRA. Our conversation shed light on how to avoid potential pitfalls and make the most of the inheritance.
“I just inherited my great aunt Harriet’s IRA. Free money is good but how do I avoid a huge tax bill?”
“Inheriting an IRA can be a financial boon, but it’s essential to understand the tax implications to avoid unexpected costs. The rules around inherited IRAs have changed in recent years, especially since the Secure Act of 2019.”
“I see,” said Edward. “I’ve heard about required minimum distributions. How does that work?”
“If Aunt Harriet was already taking required minimum distributions (RMDs), you have to take them as well. The IRS recently clarified that non-spouse beneficiaries need to start RMDs by 2025 if they haven’t already begun. Failure to take those distributions can result in a hefty penalty—an excise tax of up to 25% of the amount that should have been withdrawn.” And you would still need to take the distribution and pay the income taxes on it. Getting it wrong could cause 55–60 cents of every dollar of the IRA to disappear.
Edward sighed. “That sounds complicated. What if the account holder hasn’t started their RMDs yet?”
“In that case, you don’t have to take annual RMDs, but you need to fully withdraw the account balance within ten years of the original owner’s death. This rule applies to most non-spouse beneficiaries. And while you might be tempted to wait until the end of the ten-year period, this can lead to a big tax bill, especially if you withdraw a large sum all at once.”
“So that brings us back to my original question: How should I manage the withdrawals to minimize taxes?”
First, we need to determine if your great aunt Harriet had begun taking her required RMDs. “If she had not, consider spreading out the withdrawals over the ten-year period to avoid a large tax hit in any single year. We’ll be mindful of your tax situation and withdraw more in years when your income is lower; that will keep you in a lower tax bracket.
“Also, remember that the tax rates that were reduced by the Tax Cuts and Jobs Act of 2017 are set to expire at the end of 2025. This could also impact the timing and amount of your withdrawals.”
“What if I had inherited a Roth IRA? Are the rules different?”
“Somewhat. Roth IRAs are not subject to the same RMD requirements during the original owner’s lifetime, but as an inheritor, you still need to empty the account within ten years. The good news is that Roth distributions are tax-free, so if you don’t need the funds immediately, you can let the money grow for as long as possible within that ten-year window.”
“That’s interesting,” said Edward. “Are there exceptions?”
“A few: For instance, spouses have more flexibility; they can treat the inherited IRA as their own, and that allows them to stretch distributions over their lifetime. Additionally, minor children, heirs who are no more than ten years younger than the original account holder, and those who are chronically ill or disabled may also qualify for extended distribution periods.”
“I’m glad someone has a handle on this stuff,” said Edward. “What are our next steps?”
“We know the rules of the game so let’s take a look at your assets and income. Once we get all those pieces on the board, we’ll find a strategy that minimizes the taxes on your inherited IRA.”