The loss of a loved one is an emotional journey, but it often brings with it a complex financial responsibility: the inherited IRA. While it may feel like “their” money, once it passes to you, the Internal Revenue Service (IRS) takes a keen interest in how that money is handled. Navigating these rules isn’t just about paperwork; it’s about protecting the legacy left behind. In this blog, based on decades of financial expertise, we break down these complicated rules, the “10-year” mandate, and the strategic moves you can make to keep more of your inheritance.
The Emotional and Financial Intersection
Many things have been changing lately, and inheriting an IRA can be complicated. It’s a combination of a complex financial process and an emotional process because it’s the loss of someone that you really love or who really cared for you. Sometimes my clients feel like that’s “their” money (the deceased’s), but it’s not—it’s now yours. Because they feel like it was their parents’ money, it can be hard to make rational financial decisions. Given so many rules, people are often willing to just not think about it and leave it as is. In this blog, we will show you why that is not the best strategy.
The IRS Wants Its Share
First of all, I know it’s a difficult process, but try not to forget about that account. Don’t just say, “I don’t want to see that money; I’ll think about what I’m going to do with it later.” I’m not telling you to rush, but the IRS wants its money and will be waiting, and you can’t keep them waiting forever. That’s precisely why they created the 10-year rule that we’ve already discussed.
In traditional IRA accounts, the original owner saved for years, keeping that money tax-deferred. Now that you’ve inherited it, you are responsible for those taxes. You will be receiving a lot of money, but you will also have to pay taxes on it.
The 10-Year Rule Explained.
Why is this so important now? Many don’t know what the 10-year rule is. It came in 2019 with the SECURE Act and became effective in 2020. It’s been out there for about 5 years, so we can say it’s recent.
The most important change was this: Before, you could “stretch” your withdrawals from this account at your own pace, which was wonderful because you didn’t have the stress of having a fiscal time bomb. You could leave it there and start withdrawing money whenever you wanted. That is still okay if you are the spouse of the original owner, but it is not okay if you are a non-spouse beneficiary (a son, daughter, or anyone else).
If you are not the spouse, this is where it gets complicated. You now have a 10-year period to fully distribute—meaning withdraw all the money from—that account. You can’t just leave it there; if you do, you face huge tax implications. For those who decide to procrastinate this decision, it’s even worse because then, in year 10, you’ll have to pay taxes on withdrawing everything at once, potentially pushing you into the highest tax bracket you’ve ever been in.
Designated Beneficiaries
In this blog, we are talking about designated beneficiaries—the wife, the kids, anyone named on the account. We are not talking about charities or estates. A designated beneficiary is simply someone named on the IRA account.
If you leave the money and forget it, it keeps growing and compounding, which sounds good, but it can push you into a much higher tax bracket later. When you withdraw IRA money, it counts as income. Taking $100,000 as a lump sum in year ten is much more expensive tax-wise than taking $10,000 a year for ten years.
Spouse vs. Non-Spouse Rules
- Spousal Beneficiaries: The Most Flexibility
The 10-year rule does not apply to spouses. You have two main options:
• Roll it over: You can transfer the money into your own IRA. This delays Required Minimum Distributions (RMDs) until you reach the age required by the IRS, allowing the money to grow tax-deferred much longer.
• Inherited IRA: If you need the money now and are under 59 ½, you can treat it as an inherited IRA. You can take withdrawals without the 10% penalty, though you will still pay income tax.
Crucial Note: If the deceased was already taking RMDs (perhaps they were 73 or older), you cannot stop them. Once RMDs start, they must continue. However, as a spouse, you can use your own life expectancy table, which usually lowers the required amount if you are younger. - Non-Spousal Beneficiaries: The 10-Year Mandate
You cannot roll an inherited IRA into your own IRA. You must take all the money out within 10 years. By the end of the tenth year, the account must have a zero balance.
The Exceptions: The 10-year rule does not apply if you are:
• A minor child of the deceased (until you reach the age of majority).
• Disabled or chronically ill.
• Not more than 10 years younger than the deceased.
For everyone else, most adult children are on the 10-year clock.
Strategic Planning: How to Withdraw
Each case is different. Taking a lump-sum payment usually results in the highest tax bill.
• The “11-Year” Strategy: The 10-year clock starts the year after the owner’s death. If someone passes in November and you take a distribution that same December, you effectively have 11 years to spread the tax burden.
• Filling Tax Brackets: If you plan to retire in two years, your tax bracket will drop. You might wait until those lower-income years to start taking larger distributions.
• Geographic Moves: If you live in California (high tax) but are moving to Florida (no state income tax) next year, wait to take your distribution until you are a Florida resident.
• Medicare and Marriage: Be mindful of how extra income affects your Medicare premiums or how getting married might change your tax bracket next year.
Proactive Strategies for Account Owners
If you are the one leaving the IRA, you can help your heirs now:
• Roth Conversions: Move money from a traditional IRA to a Roth IRA now. You pay the taxes at your current rate, so your kids receive the money tax-free later. You can even have the kids help pay the current tax bill as a “gift” to protect their future inheritance.
• Increase Beneficiaries: Instead of giving everything to one high-earning child, split the IRA among children and grandchildren to spread the tax liability across more people in lower brackets.
• Strategic Allocation: If you have one child who is a high-earning consultant and another in a lower-paid profession, give the Roth IRA (tax-free) to the high-earner and the Traditional IRA to the lower-earner. This minimizes the total amount given to the IRS.
Common Mistakes to Avoid
- Missing Deadlines: The account must be empty by December 31st of the 10th year.
- Improper Rollovers: Non-spouses must use a specifically titled “Inherited IRA” account. Do not mix it with your personal IRA.
- No Named Beneficiary: If no one is named, the money goes to probate, leading to high legal fees and faster tax hits.
- Ignoring Investments: If you know you must take out large sums soon, don’t leave the money in highly risky stocks. A market crash right before a mandatory withdrawal can be devastating.
Conclusion
Inheriting an IRA is a significant financial event that requires a balance of emotional patience and technical precision. The “10-year rule” has changed the landscape, making it vital to plan your distributions rather than letting the clock run out. Whether you are a spouse looking for flexibility or an adult child managing a 10-year deadline, the goal is the same: preserve as much of your loved one’s legacy as possible by staying out of the highest tax brackets.
Secure Your Legacy
The rules are complex, and the stakes are high. Don’t navigate these waters alone. As a fiduciary and Certified Financial Planner with over 27 years of experience, I am here to ensure your inheritance is managed with the utmost care and strategic foresight.
Schedule a complimentary consultation with a Certified Financial Planner today to review your specific situation and create a customized distribution plan.
