Inherited an IRA? Don't Fall Into the 10-Year Tax Trap

If you inherited an IRA from a parent or loved one in the past few years, you may be facing a hidden tax trap. Since the passage of the SECURE Act, the rules governing inherited retirement accounts have shifted dramatically, and missteps can be costly.

While the SECURE Act rules were initially confusing, the IRS issued final regulations in July 2024 that clear the air but also set the stage for significant penalties if you fail to act.

The death of the 'stretch IRA'

For decades, beneficiaries could "stretch" distributions from an inherited IRA over their own lifetime, allowing for decades of tax-deferred growth. The SECURE Act essentially eliminated this for most non-spouse beneficiaries, replacing it with a strict 10-year rule.

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Under this rule, the entire inherited account must be emptied by the end of the 10th year following the original owner's death.

Important exceptions:

Spouses. The 10-year rule generally only applies to non-spouse beneficiaries.
Inherited Roth IRAs. While these are exempt from annual required minimum distributions (RMDs), the entire account must still be depleted by the end of the 10th year.
Minors inheriting an IRA. There are special rules that permit a delay in the 10-year rule until age 21 for minors inheriting an IRA.

About Adviser Intel

The author of this article is a participant in Kiplinger's Adviser Intel program, a curated network of trusted financial professionals who share expert insights on wealth building and preservation. Contributors, including fiduciary financial planners, wealth managers, CEOs and attorneys, provide actionable advice about retirement planning, estate planning, tax strategies and more. Experts are invited to contribute and do not pay to be included, so you can trust their advice is honest and valuable.

2025: The new RMD deadline

The original SECURE Act was ambiguous about whether you had to take money out during those 10 years or just by the end of it. The IRS has now clarified that for many, annual RMDs are required.

Because the initial law was murky, the IRS granted relief for tax years 2020 through 2024. However, that grace period is over. You must now take your RMDs or face a 25% penalty on the amount that should have been withdrawn.

A common mistake

A common mistake for those calculating their own RMDs is using the wrong IRA life expectancy table and an inaccurate calculation method.

Beneficiaries should use the IRS Single Life Expectancy table (Table I in IRS publication 590-B) to calculate their life expectancy as of the year following the original IRA owner's death. That initial life expectancy should be reduced by one each subsequent year to determine the divisor.

The danger of the 'minimum'

The traditional rule of thumb regarding IRA distributions is usually to try and keep as much in the IRA as possible for compounded tax-deferred growth.

However, that conventional wisdom should be reassessed when it comes to inherited IRAs. The reason? Waiting until the final year to empty the IRA can create a massive "tax trap".

Consider Julie, a 51-year-old who inherited a $450,000 IRA. Julie and her husband are still working and if she only takes the minimum RMD while the account grows at 5%, the IRA could be worth roughly $475,000 by year 10. Forced to withdraw that entire balance at once, over half of her inheritance could be taxed at a 35% rate based on her current income.

A smarter strategy: Equalizing distributions

Instead of taking minimum distributions each year until the final year, the goal should be to spread distributions strategically to keep your marginal tax rate as low as possible.

Take the example of Bob, who is 60 and plans to retire in three years. He also inherited a $450,000 IRA.

Years one to three. Bob takes only the minimum RMD (about $19,000) while he is still in a higher tax bracket from his salary.

Years four to 10. Once retired and in a lower bracket, he takes the remaining balance in equal amounts (about $112,000 per year).

This strategy allows Bob to maintain his lifestyle, potentially retire early, and keep his marginal tax rate in the 22% bracket rather than jumping into much higher territory.

Your inherited IRA action plan

The clock is ticking on inherited IRAs, and "Uncle Sam" is waiting to take a big bite if you don't have a plan.

Whether you are years away from retirement or ready to stop working now, if you inherit an IRA, you need to calculate your life expectancy factor (using IRS tables), take at least the minimum RMD amount each year and map out a 10-year distribution strategy that maximizes your after-tax wealth.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Mike Palmer has over 25 years of experience helping successful people make smart decisions about money. He is a graduate of the University of North Carolina at Chapel Hill and is a CERTIFIED FINANCIAL PLANNER™ professional. Mr. Palmer is a member of several professional organizations, including the National Association of Personal Financial Advisors (NAPFA) and past member of the TIAA-CREF Board of Advisors.