Is There an Inherited IRA Early Withdrawal Penalty?

An inherited Individual Retirement Account (IRA) operates under a different framework than a personal retirement account. A point of confusion for many beneficiaries revolves around the potential for penalties on withdrawals, especially if they have not yet reached retirement age.

The rules governing these accounts depend on the beneficiary’s relationship to the original owner and when the owner passed away. Understanding these regulations is the first step in managing the inheritance effectively. This guide provides a look at the withdrawal rules, penalties, and tax implications that beneficiaries face.

The 10% Early Withdrawal Penalty Exemption

A concern for many IRA owners is the 10% additional tax on distributions taken before reaching age 59½. When it comes to inherited IRAs, however, a special exemption applies. Beneficiaries are not subject to this 10% early withdrawal penalty, regardless of their age at the time they take a distribution.

This exemption applies to any beneficiary, whether they are a spouse, child, or other individual. The age of the original account owner at the time of their death also has no bearing on this penalty exemption for the beneficiary. This provision allows heirs who need to access the funds for immediate financial needs to do so without the same penalty the original owner would have faced.

It is important to distinguish this penalty from the ordinary income tax that will be due on the withdrawal. While the 10% additional tax is waived for beneficiaries, the distributions are still taxable events. The focus of this exemption is on removing the early withdrawal penalty, providing beneficiaries with more flexibility.

Withdrawal Rules for Spousal Beneficiaries

A surviving spouse who inherits an IRA has options not available to other types of beneficiaries. These choices have distinct consequences for how the funds can be accessed and when taxes must be paid. The decision hinges on the spouse’s financial situation, age, and retirement strategy.

The first option is for the surviving spouse to treat the inherited IRA as their own by rolling the assets into their existing IRA. Once this is done, the account is no longer considered inherited, and all standard IRA rules apply. If the surviving spouse is younger than 59½, any subsequent withdrawals they take would be subject to the 10% early withdrawal penalty. This option is often chosen by spouses who do not need immediate access to the funds and want to delay distributions.

Alternatively, the spouse can remain a beneficiary by transferring the assets into a new inherited IRA. An advantage of this path is that the surviving spouse can take distributions at any age without facing the 10% early withdrawal penalty. This makes it a favorable choice for a younger surviving spouse who needs to access the funds. Under this option, the timing of Required Minimum Distributions (RMDs) depends on the age of the deceased spouse.

Withdrawal Rules for Non-Spouse Beneficiaries

For non-spouse beneficiaries, the SECURE Act established a “10-year rule” for most non-spouse beneficiaries. This rule mandates that the entire balance of the inherited IRA must be fully distributed by the end of the 10th calendar year following the year of the original owner’s death.

This 10-year rule applies to “Designated Beneficiaries,” which includes most adult children, grandchildren, or other relatives. The rules for these individuals differ based on whether the original owner had started taking Required Minimum Distributions (RMDs). If the original IRA owner died before their RMD start date, the beneficiary can wait to take the entire distribution in the final year.

However, if the original owner died on or after their RMD start date, the beneficiary must take annual distributions in years one through nine, with the remainder distributed by the end of the tenth year. The IRS waived penalties for missed annual distributions for 2021 through 2024, but these annual withdrawals are required starting in 2025.

The SECURE Act created an exception to the 10-year rule for “Eligible Designated Beneficiaries” (EDBs). This classification includes the original owner’s minor children, individuals who are disabled or chronically ill, and beneficiaries who are not more than 10 years younger than the deceased account owner. EDBs are permitted to “stretch” distributions over their own life expectancy, taking smaller annual withdrawals and allowing the assets to continue growing tax-deferred.

Minor children who qualify as EDBs can take distributions based on their life expectancy only until they reach the age of 21. Once they turn 21, they become subject to the 10-year rule and must withdraw the remaining account balance by the end of the 10th year after that date.

Taxation of Inherited IRA Withdrawals

The tax treatment of money from an inherited IRA depends on whether the original account was a traditional IRA or a Roth IRA. These two account types have different tax structures that are passed on to the beneficiary.

For a traditional inherited IRA, contributions were made with pre-tax dollars, meaning the original owner received a tax deduction. Consequently, all distributions from a traditional inherited IRA are considered taxable income to the beneficiary. The withdrawn amount is added to the beneficiary’s other income for the year and is taxed at their ordinary income tax rates.

In contrast, contributions to a Roth IRA are made with after-tax dollars, so the original owner paid taxes on the money before putting it into the account. As a result, qualified distributions from an inherited Roth IRA are received free of federal income tax. For a distribution to be qualified, the Roth IRA must have been opened for at least five years before the owner’s death. Some states may have their own rules regarding the taxation of IRA distributions.