New rules for inherited IRAs could leave some heirs with a hefty tax bill. Thanks to recent changes in the law, along with a new interpretation of those changes from the IRS, your tax bill could be larger than you expect. Beneficiaries of traditional IRAs have always had to pay taxes on inherited accounts, but before 2020, you could minimize the tax bill by extending withdrawals over your life expectancy. If you inherited an IRA before 2020, you can still take advantage of that strategy to stretch out withdrawals — and taxes — over your life expectancy.
But the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was signed into law in 2019, put an end to this tax-saving strategy for most adult children, grandchildren and other non-spouse heirs who inherit a traditional IRA on or after January 1, 2020. Those heirs now have two options: Take a lump sum and pay taxes on the entire amount or transfer the money to an inherited IRA that must be depleted within 10 years after the death of the original owner. (The clock starts the year after the original owner dies, and the time runs out on December 31 of the 10th year following the year of the owner’s death, so you have a little more than a decade to empty the account. For example, if you inherited an IRA in 2020, year one is 2021 and the account needs to be cleaned out by December 31, 2030.)
The 10-year rule also applies to inherited Roth IRAs, but with a crucial difference: You are not required to pay taxes on the withdrawals, and you don’t have to take required minimum distributions (RMDs) because the original owner didn’t have to take them, either. That gives you plenty of flexibility with respect to withdrawals, but if you can afford to wait until year 10 to deplete the account, you will enjoy more than a decade of tax-free growth.
Initially, tax experts and financial planners believed that non-spouse heirs who inherited a traditional IRA would be in compliance with the law as long as they depleted the account in 10 years. That would provide them with the ability to minimize withdrawals during high-income years and take out more when their income declined — for example, during their retirement years. However, guidance issued by the IRS in February 2022 torpedoed that strategy for some heirs. If your parent died before he or she was required to take minimum distributions, you can withdraw the money at any time, in any amount you choose, as long as the account is depleted in year 10. But under the IRS interpretation of the SECURE Act, if your parent died on or after the date he or she was required to take minimum distributions, you must take RMDs based on your life expectancy in years one through nine and deplete the balance in year 10. Once the original owner has started taking RMDs, you cannot turn them off, although the IRS does not require you to withdraw the same amount as your parent would have been required to withdraw.
In response to confusion about the proposed rules, the IRS waived penalties for those who did not take RMDs that should have been taken from inherited IRAs in tax years 2021 and 2022, and in July, extended that relief for the tax year 2023. However, you may be required to start taking distributions in 2024, so it’s not too soon to plan. The penalty for missing a distribution is 25% of the amount you should have withdrawn. (The penalty will be reduced to 10% if you make up the missed RMD within two years.)
Inherited IRAs: Calculate how much to withdraw
If you’re required to take a minimum distribution from an inherited IRA, use the factor in the IRS Single Life Expectancy Table (you can find it in IRS Publication 590-B) to figure out how much you must withdraw. You’ll use the factor for your age this year and the balance of the IRA at the end of the previous year to calculate your distribution.
For example, if you are 50 and inherited a traditional IRA from someone other than your spouse with a balance of $500,000 at the end of 2022, you would divide the balance by a life expectancy factor of 36.2, for a required minimum withdrawal of $13,812.
You can, of course, withdraw more than the minimum — and in some instances, that may be a tax-savvy strategy. Distributions from a traditional IRA are taxed as ordinary income and subject to federal and, in some cases, state taxes. Even if you have the option of waiting until year 10 to empty the account, you could end up with a large distribution that will vault you into a larger tax bracket.
Unless you plan on cashing out, you need to open an inherited IRA account.
10-Year Rule for Inherited IRAs
Unless you plan on cashing out an inherited IRA — which, in the case of a traditional IRA, will trigger taxes on the entire amount — you need to open an inherited IRA account. You cannot leave the money in the original owner’s account, and unless you are a surviving spouse, you can’t roll the money into your own IRA. Instead, you must request a trustee-to-trustee transfer of funds to your inherited IRA. This is critical because if you receive a check instead, you will be taxed on the entire amount — it doesn’t matter if you turn around and reinvest the funds in an IRA.
Even if you set up an inherited IRA with a financial institution that’s home to your other retirement accounts, your inherited IRA will occupy a room of its own. It will remain in the name of the original owner, with you listed as the beneficiary, and it cannot be merged with other retirement accounts.
Once you’ve set up your inherited IRA, you can invest the money in any way you choose, based on your goals and risk tolerance. Taxes on the funds will be deferred until you take distributions, so even if you think you may empty the account in the near future, transferring funds to an inherited IRA gives you more flexibility.
The year-of-death RMD will be calculated as if the original owner were still alive, usually based on the IRS Uniform Lifetime Table. In most cases, you can arrange to take the distribution after you’ve transferred the assets to your inherited IRA. If the IRA had multiple beneficiaries, you may decide to divide the year-of-death RMD equally, but the IRS does not care how it’s allocated as long as the RMD is taken. The payout will be reported on your tax return (as well as the tax returns of any other beneficiaries who received payouts), not the estate tax return.
Inherited IRAs: Options as a spouse
If you inherit an IRA from your spouse, you have more flexibility than non-spousal heirs, but you will still have some important decisions to make.
Your options:
Treat it as your own IRA
In this case, the IRA will be treated as if you had owned it all along, with the same minimum withdrawal requirements.
Roll the IRA into your own new or existing IRA
Once you have rolled over the funds, you can postpone withdrawals until you reach the age at which you must take the required minimum distributions — 73 in 2023, increasing to 75 in 2033. You will have this option even if your spouse had started taking RMDs, although if your spouse died before taking a required distribution, you must take an RMD for that year. After you have completed the rollover, you can also convert some of the funds in your traditional IRA to a Roth. This strategy may be worth considering if you have sufficient funds outside the IRA to pay taxes on the conversion and expect to move into a higher tax bracket in the future. If you inherit a Roth, you can roll it into your own Roth and let the money grow tax-free until you need it. There are no minimum withdrawal requirements for Roths.
Transfer the funds into an inherited IRA
You may want to consider this option if you are younger than 59½ and need money to pay expenses. If you roll the funds into your own IRA and take withdrawals before age 59½, you will pay taxes on the withdrawals as well as a 10% early-withdrawal penalty. By transferring the funds to an inherited IRA, you won’t get hit with the early-withdrawal penalty. You will be required to take distributions from your inherited IRA, based on your life expectancy, but you have the option of postponing them until the latter of the year your spouse would have turned 73 or December 31 in the year following your spouse’s death. You will also have the option of rolling the account into your own IRA after you turn 59½. This will allow you to postpone distributions until you reach the age at which you’re required to take RMDs
How to leave children a tax-friendly legacy
Although your adult children are unlikely to complain if you leave them a large inheritance, taxes could significantly reduce the amount they will ultimately receive. Non-spouse heirs will be required to deplete an inherited IRA in 10 years. They may also have to take the required minimum distributions in years one through nine. Depending on their income, these withdrawals could vault them into a higher tax bracket. If you would like to lighten that burden, one strategy is to convert some of the funds in your traditional IRA to a Roth. Non-spouse heirs are required to deplete a Roth within 10 years, but withdrawals are tax-free. Better yet, because the original owner isn’t required to take RMDs, your heirs won’t have to take them, either. They can leave the funds alone until the 10th year, allowing the money to grow tax-free, or take withdrawals as needed, without worrying about a tax hit. Before converting any funds, compare your tax rate with those of your heirs. If your tax rate is much lower, converting some of your IRA funds to a Roth could make sense.