Receiving an inherited Individual Retirement Account (IRA) can provide a significant financial boost, but navigating the complex rules can be a challenge. With a massive transfer of wealth underway in the United States, more people than ever are becoming beneficiaries of these accounts, and costly errors are becoming more common.
Since 2020, most non-spouse beneficiaries, such as adult children, have been subject to a strict 10-year rule for emptying the account. Adding another layer of complexity, many of these heirs will be required to start taking annual distributions in 2025 or face substantial penalties from the IRS.
Key Takeaways
- Most non-spouse beneficiaries must empty an inherited IRA within 10 years of the original owner's death.
- Starting in 2025, many of these heirs must also take Required Minimum Distributions (RMDs) annually during that 10-year period.
- Failing to take an RMD can result in a 25% IRS penalty on the amount that should have been withdrawn.
- Poor tax planning and failing to adjust the account's investments are other common and costly mistakes.
Understanding the 10-Year Rule and New RMDs
The rules surrounding inherited IRAs changed significantly a few years ago, catching many beneficiaries off guard. The most impactful change is the so-called “10-year rule,” which generally applies to non-spouse heirs like adult children.
This rule mandates that the entire balance of the inherited IRA must be withdrawn by the end of the 10th year following the year of the original account holder's death. This is a significant departure from older rules that allowed beneficiaries to stretch distributions over their own lifetimes.
Who Does the 10-Year Rule Apply To?
The 10-year rule generally applies to most non-spouse beneficiaries. There are exceptions for certain individuals, known as “eligible designated beneficiaries,” which include surviving spouses, minor children of the account owner, disabled or chronically ill individuals, and beneficiaries who are not more than 10 years younger than the original owner. These groups may have different distribution options.
The Added Complexity of Annual Withdrawals
Initially, many believed the 10-year rule meant they could wait until the final year to withdraw the funds. However, the IRS has since clarified that if the original IRA owner had already reached the age to begin their own RMDs, then the beneficiary must also take annual RMDs during years one through nine of the 10-year period.
This requirement is set to be fully enforced starting in 2025. According to certified financial planner Brett Koeppel, founder of Eudaimonia Wealth, “the rules can get complex fast, and it’s critical to know your options.”
The Cost of Inaction
The penalty for failing to take a required minimum distribution is severe. The IRS can impose a 25% tax on the amount that should have been withdrawn but wasn't. This penalty can potentially be reduced to 10% if the mistake is corrected within a two-year window, but it remains a significant financial hit.
Mistake #2: Neglecting Proactive Tax Planning
One of the most common pitfalls for beneficiaries is failing to plan for the tax implications of their withdrawals. If you inherit a traditional, pre-tax IRA, every dollar you withdraw is taxed as ordinary income. This can easily push you into a higher tax bracket if not managed carefully.
A frequent error is taking only the minimum required distribution for the first nine years and then withdrawing the large remaining balance in the tenth year. This strategy can lead to a massive tax bill in that final year.
“This could mean significant taxes in that final year of distribution,” said John Nowak, a CFP and CPA who founded Alo Financial Planning.
Instead of this reactive approach, financial advisors recommend multi-year tax projections. This involves looking at your expected income over the entire 10-year period to determine the most tax-efficient withdrawal strategy.
Strategies for Smarter Withdrawals
A proactive plan might involve taking larger distributions in years when your other income is lower. For example, if you anticipate a temporary dip in salary or a period between jobs, that could be an opportune time to withdraw more from the inherited IRA at a lower tax rate.
By spreading the distributions out strategically, you can smooth out the tax liability and potentially keep more of the inheritance. This requires a forward-looking approach rather than simply meeting the bare minimum requirement each year.
Mistake #3: Failing to Adjust the Investments
When you inherit an IRA, you don't just inherit the money; you also inherit the investment portfolio that the original owner had in place. A critical mistake is leaving those investments untouched.
The previous owner’s investment strategy was tailored to their age, risk tolerance, and financial goals. Your financial situation is likely very different.
“It’s your money now and should be allocated according to your needs,” advises CFP Jamie Bosse, a senior advisor at CGN Advisors.
Leaving the portfolio as-is means you could be taking on too much risk—or not enough—for your own financial timeline. An older retiree’s portfolio might be heavily weighted in conservative assets, which may not be appropriate for a younger beneficiary with decades until retirement.
Aligning Investments with Your Goals and Timeline
The first step is to review the inherited portfolio and assess how it aligns with your own financial plan. This should be done in conjunction with your withdrawal and tax strategy.
John Nowak cautions that investment choices must also consider the 10-year timeline. For instance, investing in a certificate of deposit (CD) that matures after your 10-year deadline could make distributions “difficult or costly.”
The goal is to create a portfolio that balances growth potential with the need to systematically withdraw funds over the next decade. This requires a personalized strategy that considers your income needs, tax situation, and overall risk tolerance.
The Great Wealth Transfer
The importance of understanding these rules is underscored by the scale of wealth changing hands. A December report from Cerulli Associates projects that over $100 trillion will be transferred between generations through 2048, with a significant portion held in retirement accounts like IRAs.
Navigating an inherited IRA successfully requires immediate attention and careful planning. Consulting with a financial advisor or tax professional can help you understand your specific obligations, avoid costly penalties, and create a strategy that integrates the inheritance into your own financial future.
