When inheriting an IRA, beneficiaries must follow specific rules for withdrawing funds.
The SECURE Act, passed in 2019, significantly changed how inherited IRAs are handled. One of the most important changes was the introduction of the Inherited IRA 10-Year Rule, which requires most non-spouse beneficiaries to fully distribute the inherited IRA balance within ten years of the original owner’s death.
Before this rule, many beneficiaries could take required minimum distributions (RMDs) based on their life expectancy, spreading withdrawals over several decades.
The new 10-Year Rule accelerates this timeline, often leading to higher tax burdens. Understanding how the rule applies, what the distribution requirements are, and how to minimize taxes is crucial for anyone inheriting an IRA.
Who the Inherited IRA 10-Year Rule Applies To
The 10-Year Rule applies to most individuals who inherit an IRA from someone who passed away on or after January 1, 2020. These beneficiaries must withdraw the entire balance of the account within ten years, regardless of whether the funds are needed or not. This rule primarily impacts non-spouse beneficiaries, including adult children, grandchildren, siblings, extended family members, and friends.
Previously, these individuals could take distributions over their lifetime, allowing for prolonged tax-deferred growth. Now, with the compressed withdrawal period, many beneficiaries may face a significant increase in taxable income over a shorter period.
However, not all beneficiaries are subject to the 10-Year Rule. Eligible designated beneficiaries (EDBs) are exempt from this requirement and can still withdraw funds based on their life expectancy.
These include surviving spouses, minor children of the account holder (until they reach adulthood), disabled or chronically ill individuals, and beneficiaries who are less than ten years younger than the original account holder.
For those who fall into the category of non-eligible designated beneficiaries (NEDBs), proper planning is essential to avoid unnecessary tax consequences.
Distribution Requirements Under the Inherited IRA 10-Year Rule
Beneficiaries must withdraw all funds from an inherited IRA by the tenth year following the original account holder’s death. However, the specific withdrawal requirements depend on whether the original account holder had already started taking required minimum distributions (RMDs).
If the original IRA owner had not yet begun taking RMDs, the beneficiary has complete flexibility. There is no requirement to take annual withdrawals, but the full balance must be distributed by the end of the tenth year. This allows beneficiaries to plan withdrawals strategically, potentially spreading them over multiple years to manage tax liability.
If the original IRA owner had already started taking RMDs, the rules are stricter. The beneficiary must continue withdrawing annual RMDs based on their own life expectancy for the first nine years. Then, by the end of the tenth year, the entire remaining balance must be withdrawn.
Failing to take these required distributions can result in a 25% IRS penalty, which can be reduced to 10% if corrected in a timely manner.
Because these rules can be complex, beneficiaries need to review their specific situation carefully and develop a withdrawal plan that aligns with their financial goals.
Tax Planning Strategies for the Inherited IRA 10-Year Rule
The 10-Year Rule can create a significant tax burden, especially for beneficiaries inheriting large IRA balances. Without proper planning, the required withdrawals could push them into higher tax brackets. However, there are several ways to minimize tax liabilities and optimize distributions.
One effective strategy is spreading withdrawals over multiple years. Instead of taking a lump sum distribution in the final year, beneficiaries can take controlled withdrawals annually to avoid spiking their taxable income. By evenly distributing withdrawals, they may stay within a lower tax bracket and reduce the overall tax impact.
Another approach is coordinating withdrawals with lower-income years. If a beneficiary expects to have reduced earnings in certain years—such as early retirement years or temporary career transitions—it may be advantageous to take larger IRA withdrawals during those years to minimize tax exposure.
A more proactive strategy involves converting traditional IRAs to Roth IRAs before the original account holder passes away. Roth IRA distributions are tax-free, meaning beneficiaries who inherit a Roth IRA will not owe income tax on their withdrawals. While they still must withdraw the full balance within ten years, the lack of tax liability makes this an attractive option for many families.
For those who are charitably inclined, donating a portion of an inherited IRA to charity can also be beneficial. By using a charitable remainder trust (CRT) or making qualified charitable distributions (QCDs), beneficiaries can reduce their taxable income while supporting causes they care about.
Understanding these tax planning strategies can help beneficiaries maximize their inheritance while minimizing unnecessary taxes.
Exceptions and Special Cases for the Inherited IRA 10-Year Rule
While the 10-Year Rule applies to most non-spouse beneficiaries, there are exceptions and special cases that impact how inherited IRAs are handled.
One important exception involves inherited Roth IRAs. While Roth IRAs are still subject to the 10-Year Rule, the distributions are tax-free. This makes inherited Roth IRAs far more flexible than traditional IRAs because beneficiaries do not have to worry about increasing their taxable income. Spouses who inherit a Roth IRA can also treat it as their own, eliminating the 10-year withdrawal requirement altogether.
Another special case involves trusts named as IRA beneficiaries. Some trusts qualify for stretch distributions, meaning they can continue withdrawing funds over a beneficiary’s lifetime rather than following the 10-Year Rule. However, many trusts are structured in a way that forces them to withdraw the full balance within ten years. Proper estate planning is essential to ensure that trusts are structured in a tax-efficient manner.
For IRAs inherited by multiple beneficiaries, the 10-Year Rule is applied separately to each individual’s portion of the account. If one of the beneficiaries qualifies as an eligible designated beneficiary, their share may follow different distribution rules than the rest of the account.
Because these special cases can be complex, beneficiaries should consult with a tax professional to determine how best to manage their inheritance.
How the 10-Year Rule Affects Estate Planning
The 10-Year Rule has major implications for estate planning, especially for those who planned to pass down large IRAs as a long-term financial asset. With most beneficiaries now required to withdraw the full balance within ten years, tax-efficient planning is more important than ever.
Key estate planning strategies to consider include:
- Roth IRA Conversions – Converting a traditional IRA to a Roth IRA before passing ensures beneficiaries inherit tax-free funds, avoiding large taxable distributions over a short period.
- Strategic Use of Trusts – Certain trusts, like see-through trusts, may allow extended distribution schedules for eligible beneficiaries. However, improperly structured trusts may still trigger the 10-Year Rule, leading to unintended tax consequences.
- Charitable Giving – Naming a charity as an IRA beneficiary or using a charitable remainder trust (CRT) can reduce taxable estate value while supporting philanthropic causes. This strategy allows tax-free distributions for the charity and potential tax benefits for heirs.
- Annual Gifting – Instead of leaving a large IRA balance, account holders can gift assets gradually to heirs while still alive, potentially reducing the size of the inherited IRA and its associated tax burden.
- Life Insurance as an Alternative – Some individuals are choosing to withdraw IRA funds during their lifetime and use them to fund a life insurance policy, providing tax-free death benefits to heirs without the constraints of the 10-Year Rule.
With these changes, anyone with a significant IRA balance should review their estate plan to ensure their heirs are not burdened with unnecessary taxes. Consulting a tax professional can help create a tailored strategy that aligns with long-term financial goals.
Need Professional Tax Guidance?
The Inherited IRA 10-Year Rule is one of the most significant changes introduced by the SECURE Act, affecting how beneficiaries manage their inherited retirement funds. With the elimination of the stretch IRA, most non-spouse beneficiaries must now withdraw all funds within ten years, which can have major tax consequences.
Proper planning is essential to minimize the tax burden and make the most of an inherited IRA. Understanding who the rule applies to, the required distribution timelines, and available tax strategies can help beneficiaries make informed financial decisions.
For those navigating the complexities of inherited IRAs, professional tax guidance can make a significant difference. Dimov Tax specializes in tax-efficient inheritance strategies, ensuring that beneficiaries comply with IRS rules while optimizing their financial future.
Contact us today to learn how we can help you manage your inherited IRA effectively.