Dealing with the death of a loved one is hard enough. Having to navigate the complexities of inherited retirement accounts can add to that stress.
But understanding your options can help you avoid a big tax bill — particularly if you inherit a substantial amount of money.
Take Becka, a hypothetical married mother of three who inherited her mom’s individual retirement account (IRA). She needs to take a required minimum distribution (RMD) of $10,000 in 2025, but there’s no cash in the account; it’s a blend of stocks, bonds and mutual funds.
Since inherited IRAs can be quite complex, Becka may want to consult with a financial advisor or a tax professional before making any moves.
The SECURE Act 1.0 and 2.0 introduced updated rules for IRA distributions, which apply if the owner of the account passed away in 2020 or later.
Among other things, the “stretch” IRA for many non-spouse beneficiaries was eliminated, meaning that adults who inherit an IRA from a parent in 2020 or later have 10 years to empty the account.
The clock starts ticking on Dec. 31 of the year after the death of the original account owner. So if Becka’s mom passed away in 2022, she’d start calculating the 10-year period in 2023 and would have to empty the account by Dec. 31, 2032.
The amount of the RMD will depend on various factors, including the type of beneficiary, and is based on the account’s prior year-end balance.
If Becka’s mother, the original account owner, had already been taking RMDs before her death, then Becka — as a non-spousal beneficiary — would have to take annual RMDs as well.
If you miss an annual RMD, you could be slapped with a 25% excise tax on the shortfall, on top of the income taxes due on the withdrawal. Distributions from tax-deferred accounts like traditional IRAs are taxed as ordinary income.
Moreover, if there’s any cash or assets left in the account after the 10-year period is over, the remaining balance will be subject to a hefty penalty of 50%.
Read More: Vanguard reveals what could be coming for U.S. stocks, and it’s raising alarm bells for retirees. Here’s why and how to protect yourself
There are different options for different types of beneficiaries. It depends on whether you’re a surviving spouse, an adult child or family member, a minor child or an entity like a trust.
Non-spouse beneficiaries, like Becka, can’t roll the assets into their own IRA. However, a non-spouse can set up 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 so long as it’s been five years since the initial contribution.
You can’t make additional contributions to an inherited or beneficiary IRA, but the funds continue to be tax-deferred.
Becka could also take a lump-sum distribution — and, as a beneficiary, she won’t be subject to the 10% early withdrawal penalty. But it’s taxed as regular income, so it could bump her into a higher tax bracket and result in a higher tax bill.
It’s generally recommended to spread out 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 inside the traditional IRA account only become taxable when you take a distribution from the account. In Becka’s case, she’ll need to liquidate some assets inside the account in order to make a cash distribution.
However, if the IRA provider supports in-kind distribution, she may be able to take assets, such as stocks, bonds, mutual funds or ETFs, out of the account rather than cash. This could be an option for assets that are performing well or if the IRA isn’t very liquid, which could be the case, say, if it contains alternative assets like real estate.
Becka could move higher-growth assets out of the inherited IRA into 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.
She could also sell those assets inside the inherited IRA to satisfy the distribution requirements and then rebuy the assets in her own account — or use the funds from the distribution to purchase other investments based on her own risk tolerance.
Another option is to offload underperforming funds or cash out of those that performed well while they are popular and their market valuations are high. She may want to consider rebalancing the entire account with future withdrawals in mind.
The rules around inherited IRAs are highly complex. If you’re so inclined, you can review IRS Publication 590-B (1) for background information.
For bespoke advice, consider talking with a tax advisor. They can help explain your options and come up with a tax-efficient withdrawal strategy suited to your specific circumstances.
We rely only on vetted sources and credible third-party reporting. For details, see our editorial ethics and guidelines.
IRS (1).
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
