Is There a 10 Penalty on Inherited IRA Distributions?

When an individual inherits an Individual Retirement Account (IRA), a primary concern is whether withdrawals will be subject to a 10% early distribution penalty. Generally, distributions made to a beneficiary from an inherited IRA are not subject to this penalty, regardless of the age of the deceased owner or the beneficiary. While the penalty is waived, the distributions are still subject to specific withdrawal rules mandated by the Internal Revenue Service (IRS). For a traditional inherited IRA, the withdrawn amounts are included in the beneficiary’s gross income for the year and taxed at their ordinary income tax rate.

The General Penalty Exception for Beneficiaries

The IRS imposes a 10% additional tax on distributions from a traditional IRA if the owner is under age 59½, a measure intended to encourage long-term retirement savings. However, an exception exists for beneficiaries of a deceased IRA owner. The IRS does not consider distributions from an inherited IRA to be early withdrawals; instead, they are classified as death benefits. Consequently, a beneficiary can take money from an inherited IRA without incurring the 10% penalty, even if they have not reached age 59½.

It is important to distinguish this penalty waiver from the income tax liability that accompanies the distribution. For inherited traditional IRAs, funds were typically contributed on a pre-tax basis. As a result, when a beneficiary withdraws funds, that money is taxable to the beneficiary at their personal income tax rate. The waiver of the 10% penalty does not eliminate the underlying income tax obligation.

Required Distribution Timelines by Beneficiary Type

The rules governing how quickly an inherited IRA must be emptied depend on the beneficiary’s relationship to the original owner and the date of death. The SECURE Act significantly altered these timelines for many beneficiaries, making it important to understand your specific category for compliance.

Spousal Beneficiaries

A surviving spouse has unique and flexible options. The spouse can treat the inherited IRA as their own by rolling the assets into their own new or existing IRA. By choosing this path, the surviving spouse becomes the new owner, and standard IRA rules apply. This means required minimum distributions (RMDs) can be delayed until the spouse reaches RMD age, but any withdrawals before age 59½ would be subject to the 10% penalty.

Alternatively, a surviving spouse can choose to remain a beneficiary of the inherited IRA. This choice generally avoids the 10% penalty on distributions but requires the account to be depleted according to a set schedule, such as the 10-year rule.

Non-Spouse Beneficiaries

For most non-spouse beneficiaries, the rules are governed by the SECURE Act. These beneficiaries are categorized into distinct groups with different withdrawal requirements.

Eligible Designated Beneficiaries (EDBs)

A special category called “Eligible Designated Beneficiaries” (EDBs) is exempt from the most restrictive new rules. This group includes individuals who are disabled or chronically ill, beneficiaries who are not more than 10 years younger than the deceased IRA owner, and minor children of the original account owner. EDBs are permitted to take distributions over their own life expectancy, an option often referred to as the “stretch IRA.” For minor children, this special treatment ends when they reach age 21, at which point the 10-year rule applies to the remaining funds.

Designated Beneficiaries

Most non-spouse beneficiaries, such as adult children, are considered “Designated Beneficiaries.” For this group, the SECURE Act established the “10-Year Rule,” which requires the entire balance of the inherited IRA to be distributed by the end of the 10th year following the owner’s death. Whether annual withdrawals are required during this period depends on when the original owner passed away. If the owner died before their Required Beginning Date (RBD), the beneficiary is not required to take annual distributions and only needs to empty the account by the 10-year deadline. If the owner died after their RBD, the beneficiary must take annual distributions for years one through nine and withdraw the remaining balance by the end of the 10th year.

Non-Designated Beneficiaries

A third category, “Non-Designated Beneficiaries,” includes entities such as estates, charities, and certain types of trusts. These beneficiaries face the most restrictive timelines. If the original IRA owner died before their required beginning date for RMDs, the account must be fully distributed within five years.

Tax Reporting for Inherited IRA Distributions

When a beneficiary receives a distribution from an inherited IRA, the financial institution reports the transaction to the beneficiary and the IRS using Form 1099-R. This form provides the necessary details about the distribution, including the gross amount and the taxable portion.

The distribution code in Box 7 of Form 1099-R is important. For a distribution to a beneficiary after the account owner’s death, the custodian will enter Code 4, which signifies “Death.” This code signals to the IRS that the distribution is exempt from the 10% early withdrawal penalty, classifying the payment as a death benefit.

The beneficiary must then report this income on their personal tax return, Form 1040. The total distribution amount from the 1099-R is reported on the line for IRA distributions. The taxable amount is then included in the calculation of adjusted gross income (AGI) and taxed at the beneficiary’s ordinary income tax rate.

In the case of an inherited Roth IRA, the rules are slightly different. If the Roth IRA was established for at least five years before the distribution, the withdrawals are generally tax-free for the beneficiary. The beneficiary will still receive a Form 1099-R, and the distribution rules, such as the 10-year rule, must still be followed to empty the account within the required timeframe.