What Should I Do With an Inherited IRA? Tax and Distribution Options

Inheriting an Individual Retirement Account (IRA) presents financial opportunities and challenges. The decisions you make can significantly impact your financial future, particularly regarding taxes and distribution strategies. Understanding your options is essential to navigate tax implications effectively and maximize the account’s benefits.

Immediate Actions

Upon inheriting an IRA, determine the type of IRA—Traditional or Roth—as this affects tax implications and distribution rules. Distributions from Traditional IRAs are generally taxable, while Roth IRA distributions are typically tax-free if certain conditions are met.

Identify your status as a beneficiary. Spousal beneficiaries have more flexibility, such as treating the IRA as their own and deferring distributions until age 73, per SECURE Act 2.0. Non-spousal beneficiaries must adhere to stricter rules, like the 10-year rule, which requires full distribution within a decade of the original owner’s death.

Consulting a financial advisor or tax professional can help you navigate these complexities. They can provide personalized guidance, such as timing distributions to align with lower income years or leveraging charitable contributions to offset taxable income.

Beneficiary Distribution Options

Choosing a distribution strategy is crucial, as it impacts your tax burden and the inherited IRA’s growth potential.

Lump-Sum Withdrawal

A lump-sum withdrawal gives beneficiaries immediate access to the entire IRA balance. This can be helpful for those needing liquidity for major expenses. However, Traditional IRA distributions are taxed as ordinary income and could push you into a higher tax bracket. For instance, inheriting a $200,000 Traditional IRA at a 24% tax rate could result in a $48,000 tax liability. Roth IRA distributions, on the other hand, are tax-free if the account meets the five-year rule. Carefully weigh immediate financial needs against the potential tax consequences before choosing this option.

10-Year Withdrawal

The SECURE Act of 2019 introduced the 10-year rule for non-spousal beneficiaries, requiring the entire IRA to be distributed within ten years of the original owner’s death. Beneficiaries can withdraw funds strategically over this period to manage taxable income. For example, taking larger withdrawals during years of lower income can help minimize the overall tax impact. The account can also grow tax-deferred during this time, but it must be fully depleted by the end of the tenth year to avoid penalties. This strategy requires careful planning to balance tax efficiency with growth potential.

Ongoing RMD Schedule

Spousal beneficiaries can treat the inherited IRA as their own, following the Required Minimum Distribution (RMD) schedule based on their age. This allows the account to continue growing tax-deferred. Under SECURE Act 2.0, the RMD age has increased to 73, providing more time for growth. RMD calculations are based on the account balance and a life expectancy factor from the IRS Uniform Lifetime Table. For instance, a 73-year-old with a $500,000 IRA would have an RMD of approximately $19,531. This approach balances preserving the account’s growth while meeting distribution obligations.

Tax Responsibilities

Understanding the tax responsibilities of an inherited IRA is essential to avoid penalties and optimize your financial outcome. For Traditional IRAs, distributions are taxed as ordinary income, which can impact your tax bracket. Individual tax rates for 2024 range from 10% to 37%, making strategic withdrawal planning critical.

Failing to meet distribution requirements can result in penalties. For example, the SECURE Act 2.0 imposes a 25% penalty on any required amount not withdrawn within the specified timeline, such as the 10-year rule for non-spousal beneficiaries. State tax implications also vary; states like Florida and Texas do not impose income tax, while higher-tax states like California or New York may increase your liability. Consulting a tax professional can help you develop a tax-efficient withdrawal strategy that complies with federal and state regulations.

Spousal Beneficiary Paths

Spousal beneficiaries have unique options for managing an inherited IRA. One common approach is rolling the inherited IRA into their own account. This allows the funds to continue growing tax-deferred under the spouse’s IRA rules and simplifies account management.

Alternatively, the surviving spouse may choose to retain the IRA as an inherited account, which can be advantageous if they are younger than 59½ and need access to the funds. This option avoids the 10% early withdrawal penalty typically applied to personal IRAs. By keeping the account separate, the spouse can strategically access funds while maintaining flexibility.

Non-Spousal Beneficiary Paths

Non-spousal beneficiaries face stricter rules under the SECURE Act of 2019, primarily the 10-year rule, which requires the full distribution of the inherited IRA within a decade. This eliminates the option for lifetime distributions but allows beneficiaries to spread withdrawals strategically. For instance, withdrawing $50,000 annually from a $500,000 Traditional IRA can help avoid a significant tax burden in any single year. Alternatively, beneficiaries can delay withdrawals to allow the account to grow tax-deferred, provided the entire balance is distributed by the end of the tenth year.

Exceptions to the 10-year rule exist for “eligible designated beneficiaries” (EDBs), such as minor children, disabled individuals, or beneficiaries not more than ten years younger than the original owner. EDBs can follow the lifetime RMD schedule until they no longer qualify, such as when a minor reaches the age of majority. At that point, the 10-year rule applies. Consulting a tax advisor is recommended to navigate these nuanced regulations and avoid costly mistakes.