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Inheriting an IRA as a beneficiary can increase your financial security. But since inherited IRAs typically must be distributed within 10 years, the account can generate more taxable income than many beneficiaries expect. However, exceptions to this timeline are available. Here’s how distributions work and how to prepare yourself for anticipated taxes.
A financial advisor can help you evaluate distribution strategies for an inherited IRA and understand how they may affect your taxes over time.
What Is an Inherited IRA?
An inherited IRA is an individual retirement account that passes to a beneficiary after the original account owner dies. The beneficiary can be a spouse, child, other individual, trust, estate or another entity named by the owner. The tax and withdrawal rules that apply depend largely on who inherited the account and when the original owner died.
For a traditional inherited IRA, beneficiaries generally do not owe income tax simply because they receive the account. Instead, taxable distributions are generally included in the beneficiary’s gross income when withdrawn. Roth IRAs follow different tax rules, and qualified Roth distributions can generally be received tax-free.
Spouses have more flexibility than most other beneficiaries. A surviving spouse may be able to treat the inherited IRA as their own, roll eligible amounts into another retirement account or keep the account as an inherited IRA. Non-spouse beneficiaries generally cannot treat an inherited IRA as their own or make new contributions to it, although trustee-to-trustee transfers between properly titled inherited IRAs may be permitted.
For many non-spouse beneficiaries who inherit an IRA from someone who died after 2019, the SECURE Act’s 10-year rule applies. This generally requires the inherited account to be completely distributed by December 31 of the 10th year following the original owner’s death. Whether withdrawals are also required during years one through nine can depend on factors such as whether the owner died before or after their required beginning date and whether the beneficiary qualifies as an eligible designated beneficiary.
What Is the 10-Year Rule for an Inherited IRA?
The 10-year rule is a result of the Setting Every Community Up for Retirement Enhancement Act of 2019, also known as the SECURE Act. The law created several designations for IRA beneficiaries and defines which rules each designation follows. Beneficiaries following the 10-year RMD rule must drain the account entirely by the end of the 10th year after inheriting the account. This legislation was signed by President Donald Trump on December 20, 2019, and dictates what happens to IRAs inherited in 2020 and beyond.
Before the SECURE Act of 2019, federal law allowed many beneficiaries to take distributions based on the original account holder’s life expectancy. This approach, often called the “stretch IRA,” allowed for smaller withdrawals over many years, which could reduce the annual tax impact. The SECURE Act limited this treatment to certain eligible beneficiaries and generally requires most non-spouse beneficiaries to fully distribute inherited IRAs within 10 years.
You should also note that SECURE 2.0 clarified IRS enforcement of RMDs within the 10-year period. If the original account holder had already started RMDs, the beneficiary must continue taking RMDs based on their own life expectancy while also emptying the account within 10 years. If the account holder had not started RMDs, the beneficiary must empty the inherited IRA within 10 years, but does not have to take annual distributions.
Beneficiary Classes Explained
The first SECURE Act created four beneficiary classes for inherited IRAs. Understanding which class or designation applies to you will help you determine if you’re exempt from 10-year RMD rule. Here are the classes:
Designated Beneficiary
A designated beneficiary is an individual or a qualifying “see-through” trust named on the account. Most designated beneficiaries are subject to the 10-year rule, meaning the inherited IRA must be fully distributed within 10 years.
Eligible Designated Beneficiary
An eligible designated beneficiary is exempt from the 10-year rule by falling into one of the following categories:
- the surviving spouse of the account holder
- a child under age 21 of the account holder
- a disabled or chronically ill person
- a person who isn’t more than 10 years younger than the account holder
Options for distributions vary for eligible designated beneficiaries. Surviving spouses creating an inherited IRA may be able to use the original account holder’s RMD age to begin taking RMDs based on their own life expectancy. They can also roll the account over into their own IRA, but early withdrawal penalties may apply in some situations if the surviving spouse takes ownership that way.
Minor children, on the other hand, receive RMDs based on their life expectancy. They follow the 10-year rule upon turning 21.
Disabled and chronically ill beneficiaries can also use their own life expectancy because of their medical condition. And similarly, beneficiaries no more than 10 years younger than the original account holder can use their own life expectancy for RMDs.
Breaking Down the Three 10-Year Rules
The beneficiary designation is also determined by when the account holder dies in relation to their required beginning date (RBD). The RBD depends on the account holder’s RMD age. Every account holder must start taking RMDs upon reaching a specific age. The RBD is April 1 of the year after the account holder ages into RMDs.
For example, if you reach age 72 after 2022 and turn 73 before 2033, your RMD age is 73. In this case, your RBD is April 1 in the year after you turn 73. However, an account holder who dies before reaching their RBD creates different conditions than dying after their RBD. Here are the three versions of the 10-year RMD rules for beneficiaries based on the account holder’s death:
Account Holder Dies Before Their RBD
This situation means distributions are optional for the nine years after the participant’s death. However, the beneficiary must receive all of the IRA’s funds by the end of the 10th year. Remember, this condition applies to designated beneficiaries, while eligible beneficiaries can use the exceptions described above.
Account Holder Dies on or After Their RBD
In these circumstances, a designated beneficiary must take annual RMDs based on their own life expectancy. They have 10 years to empty the IRA, starting on December 31 of the year after the participant dies. In addition, if the original account holder didn’t take their first RMD, the beneficiary must receive it immediately. As with the first rule, eligible beneficiaries have exceptions.
Eligible Designated Beneficiary Dies
If an eligible designated beneficiary dies, the inherited IRA goes to the successor beneficiary. The successor takes distributions according to the eligible designated beneficiary’s life expectancy. These distributions must empty the IRA by the 10th year after the eligible designated beneficiary dies, starting with the first full year.
How Are Inherited IRAs and RMDs Taxed?
Inheriting a traditional IRA means paying standard income tax rates on distributions. Although the IRA income can raise your marginal tax rate, taking the distributions is better than the alternative: Failing to take RMDs incurs penalties as high as 25% of the annual RMD amount not taken.
On the other hand, Roth IRAs usually don’t raise your income taxes. Because the original account holder paid income taxes before contributing to the plan, withdrawals from Roth IRAs are tax-free, with one exception. If the Roth IRA was opened less than five years before the account holder passed away, the IRA’s earnings will incur income taxes unless you wait for the account to be five years old. Remember, their original contributions are still tax-free in these cases.
If you want to estimate how required minimum distributions could affect your tax bill, try using an income tax calculator to model different withdrawal scenarios.
What Can You Do With Money You’ve Inherited in an IRA?
What you can do with an inherited IRA depends largely on your relationship to the original owner and the distribution rules that apply to the account. Beneficiaries generally can take withdrawals as needed, and they may also take the entire balance as a lump sum. However, taxable distributions from a traditional inherited IRA are generally included in gross income, so taking a large amount at once could push more income into higher tax brackets.
If you inherited the IRA from a spouse, you generally have more options. A surviving spouse may be able to keep the account as an inherited IRA, roll eligible assets into their own IRA or, in some cases, treat the inherited IRA as their own. The choice can affect when required minimum distributions begin, how withdrawals are taxed and how long the money can remain invested.
Non-spouse beneficiaries generally cannot roll an inherited IRA into their own IRA or contribute new money to it. They can, however, make a trustee-to-trustee transfer to another properly titled inherited IRA. Many non-spouse beneficiaries are also subject to the 10-year rule, meaning the entire account must generally be distributed by the end of the 10th year after the original owner’s death, with annual RMDs potentially required in some situations.
The money you withdraw can then be used like other available cash, whether that means paying expenses, eliminating debt, building an emergency fund or investing through a taxable brokerage account. Because inherited traditional IRA withdrawals can create taxable income, spreading distributions across several years may help manage the tax impact instead of waiting until the end of the 10-year period and taking a much larger withdrawal.
Bottom Line
Inherited IRAs come with strict distribution rules that can vary based on your relationship to the original owner and whether required minimum distributions had already begun. Many non-spouse beneficiaries must empty the account within 10 years, and some may also need to take annual distributions during that period. Understanding the deadlines, tax consequences and available withdrawal options can help you manage the account more efficiently and avoid an unexpectedly large tax bill.
Tips for 10-Year RMD Rules for Inherited IRAs
- Whether you inherit an IRA or win the lottery, a windfall can both create a giant financial cushion while worsening your tax situation. Understanding the implications of a lump sum or monthly distributions can help you optimize your finances and create a plan to secure your future. A financial advisor can draw up a customized financial pathway to reduce taxes and invest efficiently. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re not the sole beneficiary of an inherited IRA, the situation can get more complicated. Splitting an IRA between siblings can fray relationships, and navigating the process smoothly can help save money and stress.
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