Just received an inherited IRA? If so, don't forget about taxes. For most nonspouses, it's vital to map out a withdrawal plan to reduce the tax hit on your windfall. The goal: keep as big a chunk of your inheritance as you can.
In late July, the IRS released its final rules on required minimum distributions (RMDs) on inherited IRAs under the 2020 Secure Act. The RMD stipulates how much and when money must be withdrawn from a retirement account. Given the potentially large tax impacts of the IRS rules, IBD caught up with tax and IRA expert Ed Slott to explain how IRA beneficiaries can minimize the amount of taxes they pay.
IRS Rules On Inherited IRAs
There are two key rules that could most impact the tax impact on inherited IRAs.
First is the 10-year rule. The IRS kept the 10-year rule that speeds up the withdrawal timeline to 10 years after the original IRA accountholder's death for most nonspouse beneficiaries. "(Beneficiaries) have to empty their inherited IRA account by the end of the 10th year after (the IRA owner's) death," said Slott. "(The IRS is) pushing more income into a shorter window" to boost its tax revenue.
Prior to the change, most nonspouse IRA beneficiaries, such as adult children, could stretch out their taxable distributions — and tax payments — over their lifetimes. Under the old rule (which still applies to spouses), all IRA beneficiaries had a longer runway for their account balance to grow.
Next are rules for annual RMDs for nonspouses. Beneficiaries must fully withdraw any inherited IRA balance by the end of year 10. But they are also required to take minimum distributions in years one through nine if the original accountholder died after starting RMDs, as the IRS initially proposed in February 2022.
The IRA Faucet
Slott uses the analogy of a water faucet to explain this new IRS rule requiring these annual withdrawals. "They're taking the view that once the faucet is turned on — in other words once the person you inherited the IRA has begun taking RMDs — it can't be turned off," he said.
For example, say a daughter inherited a traditional IRA from her 85-year-old mom who died in 2020. The daughter is subject to the 10-year rule and must empty the inherited IRA account by Dec. 31, 2030. And under the new regulations, the daughter will also have to take annual RMDs.
The net effect of annual RMDs is those annual withdrawals will result in taxes due and reduce the IRA account balance that can continue to grow tax-free.
In contrast, most nonspouses who inherit IRAs from account holders who had not yet reached their "required beginning date" for taking RMDs don't have to make annual withdrawals. But they still must zero out the account by the end of year 10.
To complicate matters, there was so much confusion when the proposed rules came out that the IRS waived annual RMDs in the 10-year period for years 2021, 2022, 2023 and 2024. "But now these RMDs must be taken beginning in 2025," said Slott. The good news is the IRS won't charge a penalty for failing to take them the past four years, Slott adds.
How To Save Taxes On Inherited IRAs
"Here's my advice: Ignore the 10-year rule," said Slott.
His main point? It makes little sense from a tax perspective to only take minimum distributions (a small amount of money) during the 10-year period. The reason: You want to smooth out your tax bill by taking advantage of lower tax brackets while you can.
You can do that by taking out more each year from the inherited IRA during the 10-year withdrawal period. That tax-smart strategy will enable you to avoid having to take a large, lump-sum distribution on the IRA account's remaining balance in year 10, which can bump you up into a higher tax bracket and result in a bigger tax bill.
"It's such bad tax planning to wait till year 10 (to withdraw the bulk of the account balance)," said Slott. "You'll get hit with the whole shebang."
That's especially true now for beneficiaries who inherited an IRA in 2020 and haven't taken RMDs the past four years due to the IRS waiver, adds Slott. So, now, rather than having 10 years to spread out distributions, there are only six years remaining before the account needs to be zeroed out in year 10.
"The beneficiary may even make things worse by taking only the RMD for the next five years," said Slott. "That would leave a hefty tax bill for 2030 (e.g., year 10)."
Like Paying A Credit Card Bill
Slott uses the analogy of only paying the minimum payment each month on a $4,000 credit card bill. "The minimum amount you have to pay is $41, and that feels like the deal of the century," Slott explained. "But it won't be a good deal in later months when you're paying 20%-plus in interest. So, it's the same idea with RMDs. The money you lose in taxes will really take a bite out of the inheritance."
Don't focus on the minimum distribution you can get away with paying each year on the inherited IRA. Focus instead on the maximum you can earn on your inheritance, Slott advises.
Slott also advises current IRA owners who would like to leave assets to nonspouse beneficiaries to consider converting traditional IRA savings into a Roth IRA (which are exempt from RMDs) to use up all the lower tax brackets. That way, the IRA beneficiaries won't get stuck with a big tax bill under the 10-year rule after the accountholder's death. "Anybody who inherits a Roth is never subject to RMDs," said Slott.
The bottom line: Make sure you take tax consequences into account when you're taking distributions from an inherited IRA.
