Navigating the Tax Landscape of Inherited IRAs

Upon receiving an inherited IRA, it is crucial to be mindful of the tax implications. For the majority of non-spouse beneficiaries, strategizing a withdrawal plan is essential to mitigate the tax burden and retain as much of the inherited wealth as possible.

IRS Finalizes Regulations on Inherited IRAs

In July, the IRS issued the final regulations concerning the required minimum distributions (RMDs) on inherited IRAs, as per the 2020 Secure Act. RMDs dictate the amount and timing of withdrawals from retirement accounts. Given the potential significant tax ramifications of these rules, we engaged with tax and IRA specialist Ed Slott to shed light on how beneficiaries can reduce their tax liabilities.

Key IRS Regulations Impacting Inherited IRAs

Two primary regulations have the potential to greatly affect the tax implications of inherited IRAs.

The 10-Year Rule

The IRS maintained the 10-year rule, which accelerates the timeline for withdrawals to 10 years post the original IRA account holder's demise for the majority of non-spouse beneficiaries. "Beneficiaries are mandated to liquidate their inherited IRA account by the close of the 10th year following the IRA owner's death," Slott explained. "The IRS is essentially pushing more income into a shorter timeframe to augment tax revenue."

Prior to this amendment, most non-spouse IRA beneficiaries, such as grown children, could extend their taxable distributions—and tax payments—over the course of their lifetimes. The previous rule, which continues to apply to spouses, allowed all IRA beneficiaries a more extended period for their account balance to grow.

Annual RMDs for Non-Spouses

Beneficiaries are now required to completely withdraw any inherited IRA balance by the end of year 10. Moreover, they are obligated to take minimum distributions in years one through nine if the original account holder had commenced RMDs, as initially proposed by the IRS in February 2022.

The IRA Faucet Analogy

Slott employs the analogy of a water faucet to elucidate the new IRS regulation demanding annual withdrawals. "The IRS is taking the stance that once the faucet is turned on—meaning once the individual from whom you inherited the IRA has begun taking RMDs—it cannot be turned off," he stated.

For instance, consider a scenario where a daughter inherits a traditional IRA from her 85-year-old mother who passed away in 2020. The daughter is now subject to the 10-year rule and must deplete the inherited IRA account by December 31, 2030. Additionally, under the new regulations, the daughter will be required to take annual RMDs.

The consequence of these annual RMDs is that the annual withdrawals will incur taxes and diminish the IRA account balance that could have continued to grow tax-free.

Exemptions and Waivers

In contrast, most non-spouses inheriting IRAs from account holders who had not yet reached their "required beginning date" for RMDs are not obligated to make annual withdrawals. However, they are still required to liquidate the account by the end of year 10.

Adding to the complexity, the confusion surrounding the proposed rules led the IRS to waive annual RMDs for the 10-year period for the years 2021, 2022, 2023, and 2024. "But now, these RMDs must commence in 2025," Slott noted. The silver lining is that the IRS will not impose a penalty for failing to take them over the past four years, according to Slott.

Minimizing Taxes on Inherited IRAs

"Here's my advice: Disregard the 10-year rule," Slott advised.

His primary argument is that, from a tax perspective, it is not sensible to only withdraw the minimum distributions during the 10-year period. The rationale is that you should aim to level out your tax bill by capitalizing on lower tax brackets whenever possible.

You can achieve this by withdrawing more annually from the inherited IRA during the 10-year withdrawal period. This tax-efficient strategy will help you avoid having to take a substantial, lump-sum distribution of the IRA account's remaining balance in year 10, which could elevate you into a higher tax bracket and result in a heftier tax bill.

"It's poor tax planning to defer until year 10 the withdrawal of the bulk of the account balance," Slott remarked. "You'll be hit with the entire amount."

This is particularly relevant for beneficiaries who inherited an IRA in 2020 and have not taken RMDs over the past four years due to the IRS waiver. Consequently, instead of having 10 years to disperse distributions, there are now only six years left before the account must be depleted in year 10.

"The beneficiary might even exacerbate the situation by only taking the RMD for the next five years," Slott warned. "That would result in a substantial tax bill for 2030 (i.e., year 10)."

Analogy of Credit Card Payments

Slott uses the analogy of only making the minimum monthly payments on a $4,000 credit card bill. "The minimum payment required is $41, which may seem like an excellent deal," Slott explained. "However, it won't be a good deal in the subsequent months when you're paying over 20% in interest. The same concept applies to RMDs. The taxes you forfeit will significantly detract from the inheritance."

Do not focus on the minimum distribution you can manage to pay each year on the inherited IRA. Instead, concentrate on maximizing the earnings on your inheritance, Slott suggests.

Strategies for IRA Owners

Slott also advises current IRA owners who intend to leave assets to non-spouse beneficiaries to contemplate converting traditional IRA savings into a Roth IRA (which are exempt from RMDs) to utilize all the lower tax brackets. This approach ensures that the IRA beneficiaries will not face a substantial tax bill under the 10-year rule post the accountholder's demise. "Anyone who inherits a Roth is never subject to RMDs," Slott stated.

The Takeaway

When managing distributions from an inherited IRA, it is imperative to consider the tax consequences.