Navigating Rules for an Inherited IRA

Prior to 2019, tax rules enabled the beneficiaries of traditional individual retirement accounts, or IRAs, to stretch withdrawals and the related taxes over their lifetime. However, current rules are much different, and without the right approach you may be hit with a surprise tax bill.

When the Setting Every Community Up for Retirement Enhancement, or SECURE, Act became law in 2019, it upended the rules for inheriting an IRA. Now, unless you're in special group of beneficiaries, you'll have to empty the account within 10 years. Navigating the updated rules and understanding your unique position can help you make more informed decisions.

SECURE Act changes

Under the SECURE Act, anyone inheriting an IRA after January 1, 2020, must withdraw all funds within 10 years unless they fall into a special class of designated beneficiaries. The timeline starts the year after the original owner's death and ends 10 years later on December 31. This rule applies to both traditional and Roth accounts.

The new rules carve out a distinct group of beneficiaries who aren't required to withdraw all the money within 10 years. Known as eligible designated beneficiaries, this list includes:

• The surviving spouse
• Minor children of the original IRA owner
• A beneficiary who's no more than 10 years younger than the original IRA owner
• A beneficiary who's classified as disabled or chronically ill according to IRS definitions

While an eligible designated beneficiary can use the old stretch rules and withdraw the IRA funds over their lifetime, there are a few nuances to keep in mind. For example, once a minor child turns 21, they must follow the 10-year rule.

Options for surviving spouses

Spouses have more choices when it comes to inherited IRAs. If this is your situation, you have three main options to choose from—you may transfer the inherited funds into a new or existing IRA in your name, move them into an inherited IRA account or take a lump-sum distribution.

Roll over inherited IRA assets into your own IRA

Moving assets from an inherited IRA into a new or existing IRA in your name treats an inherited IRA as if it were yours all along. If you're inheriting a traditional IRA, you have to begin taking required minimum distributions, or RMDs, when you reach age 73. The rules are changing, however, and by 2033, you must start taking RMDs at age 75.

This option also gives you the choice to convert all or a portion of a traditional IRA into a Roth IRA where the money can grow tax-free with no need to take RMDs. However, you'll need to pay taxes on the Roth conversion, so be sure to plan accordingly. On the other hand, if you're inheriting a Roth IRA that has been open for at least 5 years, you can transfer the funds to your own Roth IRA and let it grow until you're ready to take withdrawals.

Transfer assets into an inherited IRA in your name

If you're younger than 59½ and want access to the money before you reach that age, this may be an option to consider because money you withdraw won't incur the 10% early withdrawal penalty. Otherwise, you'll need to take RMDs based on your life expectancy. However, you can delay them until the year your spouse would have turned 73 or December 31 of the year after their death—whichever is later.

Withdrawals from a traditional inherited IRA are taxable, but all withdrawals from an inherited Roth IRA are tax-free if the original account—or the inherited account in your name—has been open for at least 5 years. If not, the earnings are subject to taxes.

Take a lump-sum distribution

While rarely advised due to the tax implications, cashing in an inherited IRA may make sense in a few unique situations. The decision to take a lump-sum distribution depends on your current income and tax situation, the balance of the inherited IRA and your financial goals—such as buying a house or starting a business.

With a traditional IRA, this option comes with a large tax bill. With a Roth IRA, the withdrawal is tax-free, but only if the account has been open for 5 years or more. If not, earnings are taxable.

Options for standard beneficiaries

If you're not an eligible designated beneficiary, your options are more limited. You may take a lump-sum distribution, or you may transfer the inherited IRA assets to an inherited IRA in your name and distribute the assets within 10 years.

The 10-year rule applies whether the IRA you've inherited is a traditional or Roth. However, there are vastly different tax consequences for each possibility.

Inheriting a traditional IRA

If you've inherited a traditional IRA, you'll have to pay income taxes on the money you withdraw. If the person you inherited from was already taking RMDs, you may need to do the same. Regardless of whether you're required to take RMDs, the account must be fully depleted by the end of the 10-year timeline.

Inheriting a Roth IRA

If the Roth IRA you've inherited was open for at least 5 years, you won't be taxed on the money you withdraw. However, earnings may be subject to taxes if the account was open for a shorter period. If you've inherited a Roth IRA, you also won't be required to take RMDs, which means you can wait until the 10th year to empty the account. This may allow you to take advantage of any future growth.

RMDs for inherited IRAs

If you've inherited an IRA, it's important to be aware of a special rule that applies if the account's original owner was taking RMDs before they died. If so, the beneficiary must continue taking RMDs throughout the first 9 years before completely emptying the account by the end of the 10th year.

The IRS penalizes taxpayers who don't take their required distributions—up to 25% of the amount that should have been withdrawn. However, delays in guidance have created some confusion.

"The IRS has not told us how to calculate those RMDs for inherited IRAs. Four years have gone by since the SECURE Act passed, and we still have no guidance from the IRS," notes Tammy Harrison, AFTA, CISP and IRA specialist for First Citizens. "[As a result], the IRS decided not to penalize people who didn't take their RMDs—if they're included in this group—in 2023."

Individuals inheriting an IRA should watch for updated IRS guidance in 2024. In addition, a financial professional or tax specialist may be able to help you determine how to effectively handle required distributions moving forward.

Investing the inherited funds

Even with a shorter timeline to withdraw funds from an inherited IRA, you can still invest the funds according to your priorities. The 10-year timeline still gives you plenty of time to potentially grow those assets in a tax-advantaged way.

Plus, you don't have to stick with the original investments if they don't match your risk tolerance and financial goals. "Out of the gate, you inherit the original assets in the IRA. But you can choose a different investment objective for the new inherited IRA," Harrison says.

The bottom line

Under the SECURE Act, rules for inherited IRAs can be tricky to navigate and have significant tax consequences. Eligible designated beneficiaries are allowed to withdraw funds from an inherited IRA over their lifetime—with some important nuances. However, many other beneficiaries must withdraw all funds within 10 years.

Spouses have several options when making decisions about inherited IRAs, but non-spouse beneficiaries have more limitations. Regardless, the tax consequences will depend on whether the inherited IRA is a traditional or Roth. If you inherit an IRA, you should become familiar with the rules regarding required minimum distributions and consider reinvesting assets to support your financial goals.