Inheriting an IRA might feel like a financial win, but the rules today are different than they were just a few years ago. If you’re not up to date, an unexpected tax bill could catch you off guard. Here’s what changed, and how to plan around it.
Changes Made by the SECURE Act
The SECURE Act of 2019 eliminated the “stretch IRA,” which allowed inherited funds to grow tax-deferred for decades while keeping annual withdrawals relatively low. Now, many non-spousal heirs must withdraw the entire inherited IRA within 10 years of the original owner’s death.
This is the 10-year rule, and it can be a tax trap for non-spouse beneficiaries.
If the IRA is traditional, any withdrawals are taxed as ordinary income. If you wait and withdraw everything in year 10, it could push you into a much higher tax bracket.
Who Gets a Pass from the 10-Year Rule?
Not everyone is subject to the 10-year rule. The IRS created a category called “eligible designated beneficiaries.” Beneficiaries in this category can still stretch distributions over their life expectancy. They include:
- A surviving spouse
- A minor child of the deceased IRA owner (until reaching adulthood)
- A disabled beneficiary
- A chronically ill beneficiary
- A beneficiary who is no more than 10 years younger than the original owner
A surviving spouse has the most flexibility. They can roll the inherited IRA into their own IRA and treat it as their own account, which allows them to follow standard RMD rules based on their age.
Minor children who inherit an IRA can take RMDs based on their life expectancy until they reach age 21. After that, the 10-year rule kicks in.
Why the 10-Year Rule Can Be a Problem
The 10-year rule can be problematic for tax purposes. If you inherit an IRA with significant funds and you’re forced to withdraw it within 10 years, those withdrawals could push you into a higher tax bracket. And that, of course, means paying more to the IRS than necessary.
It’s important to note that the 10-year rule enacted in the SECURE Act only applies to IRAs inherited in 2020 and beyond. If you inherited an IRA before 2020, you’re still covered under the old rules.
How to Avoid the Tax Trap
The key is in planning. Don’t wait until the ninth year to make withdrawals. Instead:
- Spread withdrawals over the 10-year period to manage your tax bracket.
- If possible or applicable, coordinate distributions with lower-income years.
- Work with a tax advisor to help you work through different withdrawal strategies.
Here’s the bottom line: the SECURE Act changed the rules for inherited IRAs, and without careful planning, the 10-year requirement can create significant tax bills for beneficiaries. Be prepared, understand the timing, and work with a tax professional to reduce the impact.
