If you’ve recently come into an individual retirement account (IRA) through inheritance, you might be excited about the potential financial boost. However, it’s important to tread carefully, as experts warn that missteps could reduce your windfall significantly.
Many investors opt to roll over pre-tax 401(k) plans into traditional IRAs, which means that any future withdrawals will be subject to ordinary income taxes. Understanding the rules around these inherited IRAs can be complex, especially for heirs.
According to a Fidelity report examining 16.8 million IRA accounts, the average IRA balance stood at $127,534 in the closing months of 2024—a notable increase of 38% since 2014. Nonetheless, these balances can sometimes be much higher, and making mistakes could be costly, says Denise Appleby, a specialist in IRAs and the CEO of Appleby Retirement Consulting in Grayson, Georgia.
More insights from Personal Finance include:
– New changes to inherited IRA rules for 2025 that could lead to a hefty 25% tax penalty.
– A report revealing that half of today’s parents are still financially aiding their adult children.
– The Treasury’s decision to scrap a reporting rule for small U.S. business owners.
Let’s delve into some common pitfalls with inherited IRAs and how you can sidestep them, based on advice from financial experts.
### Decoding the ’10-year rule’
Prior to the Secure Act of 2019, heirs could stretch an inherited IRA’s withdrawals over their lifetime, thus minimizing the annual tax hit—a strategy often referred to as the “stretch IRA.” However, since the beginning of 2020, many heirs must adhere to the “10-year rule,” requiring the IRA to be fully distributed by the end of the tenth year following the original owner’s death. This affects beneficiaries who aren’t a spouse, minor child, disabled or chronically ill individual, or certain trusts.
Denise Appleby notes that many heirs are still unclear about how this 10-year rule functions, which could prove costly. Failing to deplete the account within the decade results in a 25% IRS penalty on the outstanding balance you should have withdrawn. Luckily, this penalty can be reduced or even waived if the hiccup is rectified within two years.
### Inherited IRAs: A looming tax dilemma
Regarding pre-tax inherited IRAs, Trevor Ausen, a certified financial planner and founder of Authentic Life Financial Planning based in Minneapolis, warns against holding off until the last year to start withdrawing substantial amounts. Waiting until the tenth year can result in a substantial tax bill all at once, potentially pushing you into a much higher tax bracket.
Similarly, caution is advised against immediately cashing out an inherited IRA without understanding the tax consequences, suggests IRA specialist and certified public accountant Ed Slott. Doing so could likewise bump you into an elevated tax bracket, depending on your IRA’s size. It’s akin to a “smash and grab,” he notes.
Instead of draining the IRA all at once, financial advisors often suggest devising a withdrawal strategy over several years or during times when you have reduced income, as this could be more tax-efficient, depending on current tax brackets.
### Required minimum distributions coming in 2025
Starting in 2025, most non-spouse heirs will need to start taking required minimum distributions (RMDs) while exhausting the inherited IRA over a 10-year span—if the original account holder had reached RMD age prior to their passing, according to new regulations finalized in July.
Unexpectedly to some, the IRS has previously waived penalties for missed RMDs from inherited IRAs, but this may not continue, experts caution.
While your IRA custodian calculates your RMD, discrepancies might arise, Appleby points out. Complications can occur, for instance, if you rolled over a balance in December or if there’s a significant age gap between you and your spouse. Communicating these situations to your tax advisor is crucial.
To determine your annual RMD, you should divide your account balance (as of the previous December 31) by a “life expectancy factor,” which is outlined by the IRS. Missing RMDs or withdrawing insufficient amounts in 2025 could result in a 25% penalty on the amount that should have been taken, or 10% if corrected within two years.
However, taking quick action to fix the oversight—by submitting Form 5329 along with a letter of explanation—might persuade the IRS to waive the penalty. “Address it in the first year and assure the IRS it won’t happen again,” advises Appleby.
