Dealing with the death of a loved one is difficult enough. Having to navigate the complexities of inherited retirement accounts can add to that stress.
But understanding your options can help you avoid a large tax bill, especially if you inherit a substantial amount of money.
Take Becka, a hypothetical married mother of three who inherited her mother’s individual retirement account (IRA). You need to take a required minimum distribution (RMD) of $10,000 in 2025, but there is no cash in the account; It is a combination of stocks, bonds and mutual funds.
Since inherited IRAs can be quite complex, Becka may want to consult with a financial advisor or tax professional before making any moves.
The SECURE Act 1.0 and 2.0 introduced updated rules for IRA distributions, which apply if the account owner died in 2020 or later.
Among other things, the “stretch” IRA was eliminated for many non-spouse beneficiaries, meaning adults who inherit an IRA from a parent in 2020 or later have 10 years to empty the account.
The clock begins to run on December 31 of the year after the death of the original account owner. So if Becka’s mother died in 2022, she would start calculating the 10-year period in 2023 and would have to empty the account by December 31, 2032.
The amount of the RMD will depend on several factors, including the type of beneficiary, and is based on the account’s previous year-end balance.
If Becka’s mother, the original owner of the account, had already been taking RMDs before her death, then Becka, as the non-spousal beneficiary, would also have to take annual RMDs.
If you fail to meet an annual RMD, you could be assessed a 25% special tax on the shortfall in addition to any income taxes due on the withdrawal. Distributions from tax-deferred accounts, such as traditional IRAs, are taxed as ordinary income.
Additionally, if any cash or assets remain in the account after the 10-year period is over, the remaining balance will be subject to a hefty 50% penalty.
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There are different options for different types of beneficiaries. It depends on whether you are a surviving spouse, adult child or relative, minor child, or an entity such as a trust.
Non-spouse beneficiaries, like Becka, cannot transfer the assets to their own IRA. However, someone other than your spouse can establish an inherited IRA (sometimes called a beneficiary IRA). This is the case whether you inherit a traditional or Roth IRA.
While a Roth IRA, which is funded with after-tax dollars, is still subject to the 10-year rule, distributions are tax-free as long as five years have passed since the initial contribution.
You cannot make additional contributions to an inherited or beneficiary IRA, but the funds remain tax deferred.
Becka could also accept a lump sum distribution and, as a beneficiary, will not be subject to the 10% early withdrawal penalty. But it is taxed as regular income, so it could put you in a higher tax bracket and result in a higher tax bill.
It is generally recommended to spread distributions over 10 years to reduce your tax burden, but working with a tax professional can help you figure out what makes the most sense for your situation.
The cash and assets within the traditional IRA are only subject to taxes when a distribution is taken from the account. In Becka’s case, she will need to liquidate some assets within the account in order to make a cash distribution.
However, if the IRA provider supports in-kind distribution, you may be able to withdraw assets, such as stocks, bonds, mutual funds, or ETFs, from the account instead of cash. This could be an option for assets that are performing well or if the IRA is not very liquid, which could be the case, for example, if it contains alternative assets such as real estate.
Becka could move higher-growth assets from the inherited IRA to her own account through an in-kind distribution. However, in-kind distributions are still treated as taxable income and will need to be reported on your tax return.
You could also sell those assets within the inherited IRA to satisfy the distribution requirements and then buy back the assets in your own account, or use the funds from the distribution to purchase other investments based on your own risk tolerance.
Another option is to get rid of underperforming funds or withdraw funds from those that performed well while they are popular and their market valuations are high. You may want to consider rebalancing the entire account taking future withdrawals into account.
The rules on inherited IRAs are very complex. If you wish, you can review IRS Publication 590-B (1) for general information.
For personalized advice, consider speaking with a tax advisor. They can help explain your options and propose a tax-efficient withdrawal strategy that suits your specific circumstances.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
