Anyone that’s ever received an inheritance knows it can quickly get complicated. There’s a shocking amount of rules, steps, and blind spots that govern the process.
One area where we find many misconceptions is with inherited retirement accounts (IRAs). If you inherited an IRA in the last few years, there are three things you need to be aware of:
- The new 10-year rule for withdrawals
- How IRAs affect your tax planning
- How your season of life guides what you do with that money
Understanding the 10 Year Rule and Secure Act 2.0
The Secure Act 2.0 changed the rules on inherited IRA distributions for any non-spousal beneficiary who receives money in an inherited IRA since January 1, 2020. It’s geared toward non-spousal inheritors – children, nieces, nephews, grandchildren, family friends, etc.
The Secure Act 2.0 declared that you have 10 years from the end of the year the individual passed to empty out the entire IRA. As an example, if a parent passed away in 2021 and you were named as a beneficiary on their IRA, you have until December 31, 2032, to fully drain your inherited IRA balance.
Initially, the rules in Secure 2.0 were not clear, and there was confusion over whether minimum distributions (RMDs) were required, or if the inherited IRA account just had to be zeroed out within the 10-year window. The IRS has since provided clarification, stating that there will be no penalty for previously untaken RMDs, but beginning in 2025, you do need to begin taking an annual RMD. Many families are still unaware of the 10-year rule, let alone the updated rules around RMDs. Without a plan, those families can easily find themselves on the hook for a potentially substantial tax bill if they haven’t planned.
How Inherited IRAs Affect Your Tax Planning
The tax piece is really where most folks start the inherited IRA planning conversation. Inheritances are a bit of an anomaly, and the tax component catches many families off guard. Worse, you can face up to a 25% tax penalty for missed RMDs, starting in 2025.
Unless you’re receiving funds from an inherited Roth IRA, inherited traditional IRAs are taxed as income when you take distributions. That means taking RMDs over 10 years can drive up your tax bill, potentially even driving you into another tax bracket.
And if your RMDs aren’t expected to fully deplete your inherited IRA by the end of the 10-year window, you’ll want to come up with a plan around how to zero out the account within the 10-year timeframe.
The good news is that the 10-year window does give you some flexibility to arrange how much of the funds you withdraw each year. You have the ability to take smaller distributions (like maybe only your RMD) when your earned income is higher and vice versa.
There are generally four options most people consider:
- Lump-sum Distributions: Some inheritors take the funds up front, biting the bullet on the taxes to fund another project or investment.
- Paced Distributions: Others may opt to spread out the distributions over time to limit their tax liability in any one year. This is typically the way we see most people handle their inherited IRAs. They plan to distribute roughly 10% of the account’s initial value each year, spreading the tax liability evenly over the 10 years.
- Fund Your IRA with Distributions: Pay the tax bill now on the annual distributions and invest the remaining proceeds into your own traditional or Roth IRA. This is often done in conjunction with the paced distributions, when clients are eligible to contribute to their own IRAs.
- Bridge the Gap to Retirement (or Lower Earned Income): For those who are in the later years of working and expect to retire or slow down within 10 years of receiving an inherited IRA, they can take the RMD every year until they retire (or slow down) and then begin taking larger distributions to deplete the account once their earned income has decreased and they are presumably in a lower tax bracket. This helps bridge the income gap between retirement and a delayed, higher social security benefit.
What You Can Do With Your Inherited IRA
What you do with IRA funds is entirely a matter of what season of life you are in and what your financial situation looks like. That said, here are a few common planning conversations.
Younger Households
Some of our younger clients are still working and funding their own IRAs. They’ve used inherited IRA distributions to fund their own traditional or Roth IRA contributions, when possible. They pay the taxes on the inherited IRA distributions now, and then put the money into their own IRAs, allowing it to grow tax-deferred into their own retirement.
Nearing or In Retirement
For those who are approaching or in their retirement years, we have a few more interesting options. For example, some of our clients have used distributions from their inherited IRA to hold off on claiming Social Security for as long as possible. As a result, they can take an increased Social Security benefit for the rest of their lives.
Making Your Decision
If you only get one takeaway from this article, let it be this: If you receive an inherited IRA, have an informed distribution plan to make the most of those funds.
Better yet, talk to someone who can help guide you through the rules and possible decisions. At Courage Korving Miller Partners, we are here to help you identify the best decision for you.