Did you inherit a retirement account recently and have no clue what to do with it? Inheriting a retirement account from a spouse or parent can be confusing, especially if this is the first time you have received one. Since the SECURE Act took effect in late 2019, the rules around inherited IRAs have changed, making it more complicated to decide how to manage these accounts. To avoid costly mistakes, the key is to understand how the account works, what rules apply, and which strategy you will use for the account.
The Basics of Inherited IRAs
An Inherited IRA, Beneficiary IRA, Decedent IRA, etc., are all different names for one specific retirement account that people inherit from another person. Likely, you were listed as a beneficiary for a deceased parent or relative and were required to open this new IRA to receive the money. Once opened, a game of tax rates starts with the government, especially if the account is a traditional IRA. For nearly all inherited traditional IRAs, distributions from the account will count towards your taxable income. For inherited Roth IRAs, there is significantly less concern around taxes since the original owner already paid the taxes.
For years, the normal instructions for these accounts were to distribute a small amount each year, but you could essentially own the account for as long as you wanted. Many people referred to these accounts as Stretch IRAs for this reason. You could generally “stretch” the beneficiary IRA for the rest of your life without being required to close the account. This was preferable for people who inherited large accounts that did not want to pay taxes to distribute.
However, as of July of 2024, Congress finalized new regulations around these beneficiary IRAs. One of the primary changes centered around the removal of the Stretch IRA for many people. Certain “Eligible Designated Beneficiaries”, such as a spouse, minor child, disabled person, or someone within 10 years of the deceased, can still “stretch their IRA”. For mostly everyone else, specifically adult children of elderly deceased parents, Congress implemented a new 10-year rule where all beneficiary IRAs must be emptied by the 10th year after the original owner’s death. This is when things become complicated.
The Rules of Inherited IRAs
There are two main rules to address in the new era of beneficiary IRAs. The first is the duration that the account can be opened. For most people, Congress has reduced the duration down to either 10 or 5 years. Why is this important? Instead of literally waiting a lifetime, Congress can collect more taxes sooner as these types of accounts are inherited. You can imagine a 40-year-old receiving a $1,000,000 beneficiary traditional IRA. Congress wants to tax those million dollars within the next 10 years as opposed to the next 40.
The second important rule to comprehend is whether you must distribute money from the account each year. To determine if you must take money out the first year of your account, you need to know if the deceased was already taking money out each year. These distributions are referred to as Required Minimum Distributions (RMDs), where individuals with traditional IRAs over 72 (or 73, depending on their age) are forced to distribute some money each year. In an oversimplified manner, if the original owner had started RMDs, the beneficiary will likely also need to take out RMDs.
With these two general rules in mind, it is important to work with a professional to understand the exact rules you are required to follow. For example, adult children of parents who passed in their 80s will likely have the 10-year rule and have RMDs each year. Adult children with parents who passed in their 60s will likely have the 10-year rule but no RMDs each year. A spouse (or sibling less than 10 years younger than the deceased) may not have any 10-year rule or RMD. The relationship to the decedent and the age at death are two critical factors to help determine which rules apply.
What to Do With Your Inherited IRA.
Sticking with the scenario of an adult child inheriting an IRA from a parent in their 80s, the question eventually turns to what to do with the account. I think there are three major strategies to consider, given the 10-year rule.
First, take it all out once you receive it. Usually, this is not the most tax-efficient solution, but it may be the most practical. I recently met with a business owner who decided to empty the beneficiary IRA he just received from his mother to help support his business and invest in real estate. From a tax standpoint, taking the full balance out in the first year will likely mean it will be taxed at your top marginal tax rate. Especially if the sum bumps you into a higher tax bracket, it could be costly. But again, taxes are one variable to solve for. Sometimes, paying off debt or other investments could offset the costs.
The second strategy would be to take out a proportional amount each of the 10 years. Instead of taking all $1,000,000 in the first year, distribute $100,000 each year for 10 years. This allows you to take less of a tax hit each year and spread the taxes over time. I’d argue this is the most conservative approach, but it may be less specific to your current financial situation. For example, if you knew your income would be less in years 5-10 because you are planning a sabbatical or your spouse will stop working, it could be much more advantageous to pull out the money in the later years as opposed to each year.
The third strategy is essentially the opposite approach, where you distribute nothing (or the minimum required amount) each year. If you are given 10 years, this strategy is essentially the opposite of the first, where you roughly plan to distribute the funds at the end of year 10. The positive side of this strategy is that you are prepared for anything unexpected that may happen. You could maximize that sabbatical or loss of income from the spouse, for example. However, this strategy does risk bunching all distributions into the final year if you never pull anything out, and you are left with the same downside as the first strategy.
Inheritances Are a Blessing.
At the end of the day, it is a blessing that you were able to inherit money. The new rules around these beneficiary IRAs make the process more complicated, but it shouldn’t take away from the gift itself. If you’ve inherited an IRA, don’t wait until tax time to figure things out. Talk with a financial professional to confirm whether the 10-year rule applies, what your RMD requirements are, and how to structure withdrawals to minimize taxes. A little planning now can help you avoid a major tax hit later, as well as improve your overall financial plan.
TC Falkner 