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When inheriting an individual retirement account (IRA), recipients often find themselves managing significant assets. However, missteps can greatly diminish this financial boon, according to experts in the field.
Heirs frequently convert pre-tax 401(k) plans into traditional IRAs, which leads to the imposition of regular income taxes upon withdrawal. Unfortunately, the tax regulations for those inheriting these IRAs are quite complex.
Recent data indicates that the average IRA balance reached $127,534 in the fourth quarter of 2024, a notable increase of 38% since 2014, according to a Fidelity evaluation of 16.8 million IRA accounts as of December 31.
However, some inherited IRAs are substantially larger, and mistakes can result in high costs, warns Denise Appleby, an IRA specialist and CEO of Appleby Retirement Consulting based in Grayson, Georgia.
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Below are some common pitfalls related to inherited IRAs and strategies to navigate them effectively, as advised by financial professionals.
Understanding the ’10-Year Rule’
Prior to the implementation of the Secure Act of 2019, heirs were allowed to withdraw funds from inherited IRAs over their lifetime in a strategy called the “stretch IRA.” However, as of 2020, many beneficiaries are required to adhere to the “10-year rule,” which mandates that IRAs be fully depleted by the end of the 10th year following the original owner’s death. This rule primarily applies to beneficiaries who are not a spouse, a minor child, disabled, chronically ill, or certain trusts.
Many heirs remain unaware of how the 10-year rule functions, which could be financially detrimental, according to Appleby.
Failing to withdraw the necessary amounts within this timeframe could result in a 25% IRS penalty on the missed withdrawals, although this may be reduced or eliminated if the error is corrected within two years.
The Tax Implications of Inherited IRAs
When managing pre-tax inherited IRAs, one significant error could be waiting until the last year to withdraw the bulk of the account’s balance, as pointed out by certified financial planner Trevor Ausen, founder of Authentic Life Financial Planning in Minneapolis. He described this scenario as a “ticking tax bomb,” cautioning that a large withdrawal could escalate an individual into a higher tax bracket due to the surge in taxable income.
Furthermore, some heirs cash out their inherited IRA shortly after receipt without carefully considering the tax ramifications. Ed Slott, an IRA specialist and CPA, likened this hasty decision to a “smash and grab,” emphasizing that it can similarly push recipients into a higher tax bracket based on the size of the account.
Instead of taking all funds at once, financial advisors commonly recommend conducting multi-year tax projections to assist heirs in determining the most advantageous timing for withdrawals from the inherited account.
Generally, it is advisable to space out withdrawals across the ten-year period, or opt for withdrawals during years with lower income levels, depending on individual tax situations.
Impending RMD Requirements for Many Heirs in 2025
Beginning in 2025, most non-spouse heirs will be required to take required minimum distributions (RMDs) while depleting inherited IRAs over the course of ten years, especially if the original account holder reached the RMD age prior to their passing, per new regulations released in July.
This may catch some beneficiaries off guard, since previously, the IRS had waived penalties for missed RMDs on inherited IRAs. It’s important to note that while custodians are responsible for calculating RMDs, inaccuracies can occur, as Appleby explained. For instance, discrepancies might arise if a balance was rolled over in December or if there’s a significant age difference between the beneficiary and spouse.
To determine RMDs, you typically divide the previous year’s December 31 balance by a “life expectancy factor” specified by the IRS.
Failure to withdraw RMDs or falling short on amounts due in 2025 could lead to a 25% penalty on the minimum amounts that should have been withdrawn, or a reduced 10% penalty if corrected within two years. However, the IRS may waive such penalties if corrective actions are taken promptly, including submitting Form 5329 along with an explanatory letter. Appleby advises making corrections in the first year and informing the IRS of intentions to prevent future issues.
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