Inherited IRAs and the 10-Year RMD Rules: What You Need to Know

Inheriting an IRA as a beneficiary can increase your financial security. But, because an inherited IRA usually imposes a 10-year distribution schedule, the account may also create larger tax implications than expected. However, exceptions to this timeline are available. Here’s how distributions work and how to prepare yourself for anticipated taxes.

A financial advisor can help optimize your retirement plan to minimize taxes.

What Is an Inherited IRA?

An inherited IRA is an individual retirement account (IRA) that you receive if the original accountholder passes away and listed you as the beneficiary of the account. You can also inherit an IRA through the probate process if the original account holder doesn’t name a beneficiary before passing away.

Inheriting an IRA means receiving ownership of a financial account with several rules. You can opt to take all the money as a lump sum, set up required minimum distributions (RMDs) to flow to you over 10 years, or take irregular distributions. That being, said, you usually need to empty an inherited IRA within 10 years. There are exceptions to this rule, which will be explored below. However, it’s crucial to understand the 10-year RMD rule for inherited IRAs before doing so.

What Is the 10-Year RMD Rule for an Inherited IRA?

The 10-year RMD rule is a result of the Setting Every Community Up for Retirement Enhancement Act of 2019, also known as Secure 1.0. The law creates several designations for IRA beneficiaries and defines which rules each designation follows. Beneficiaries following the 10-year RMD rule must drain the account entirely by the end of the 10th year after inheriting the account. This legislation went into effect on December 20, 2019, and dictates what happens to IRAs inherited in 2020 and beyond.

Before the legislation in 2019, federal law allowed beneficiaries to receive distributions based on the old account holder’s life expectancy. As a result, inheriting an IRA meant you could receive tiny distributions for decades, minimizing the tax consequences for this new stream of income. Secure 1.0 eliminates this possibility for most beneficiary classes and imposes a 10-year RMD schedule to prevent IRAs from lingering in a taxpayer’s possession.

Legislation has a tendency to change. Consider matching with a financial advisor who can help you stay on top of changes.

Beneficiary Classes Explained

Secure 1.0 created four beneficiary classes for inherited IRAs. Understanding which class or designation applies to you will help you determine if you’re exempt from 10-year RMD rule. Here are the classes:

Designated Beneficiary

A designated beneficiary can be a person or a see-through trust. Designated beneficiaries follow the 10-year rule unless they’re eligible for an exception.

Eligible Designated Beneficiary

An eligible designated beneficiary is exempt from the 10-year rule by falling into one of the following categories:

• the surviving spouse of the account holder

• a child under age 21 of the account holder

• a disabled or chronically ill person

• a person who isn’t more than 10 years younger than the account holder

Options for distributions vary for eligible designated beneficiaries. Surviving spouses creating an inherited IRA may be able to use the original account holder’s RMD age to begin taking RMDs based on their own life expectancy. They can also roll the account over into their own IRA, but early withdrawal penalties may apply in some situations if the surviving spouse takes ownership that way.

Minor children, on the other hand, receive RMDs based on their life expectancy. They follow the 10-year RMD rule upon turning 21.

Disabled and chronically ill beneficiaries can also use their own life expectancy because of their medical condition. And similarly, beneficiaries no more than 10 years younger than the original account holder can use their own life expectancy for RMDs.

Breaking Down the Three 10-Year Rules

The beneficiary designation is also determined by when the account holder dies in relation to their required beginning date (RBD). The RBD depends on the account holder’s required minimum distribution (RMD) age. Every account holder must start taking RMDs upon reaching a specific age. The RBD is April 1 of the year after the account holder ages into RMDs.

For instance, if you reach age 72 after 2022 and turn 73 before 2033, your RMD age is 73. In this case, your RBD is April 1 in the year after you turn 73. However, an account holder who dies before reaching their RBD creates different conditions than dying after their RBD. Here are the three versions of the 10-year RMD rules for beneficiaries based on the account holder’s death:

The Account Holder Dies Before Their RBD

This situation means distributions are optional for the nine years after the participant’s death. However, the beneficiary must receive all of the IRA’s funds by the end of the 10th year. Remember, this condition applies to designated beneficiaries, while eligible beneficiaries can use the exceptions described above.

The Account Holder Dies on or After Their RBD

In these circumstances, a designated beneficiary must take annual RMDs based on their own life expectancy. They have 10 years to empty the IRA, starting on December 31 of the year after the participant dies. In addition, if the original account holder didn’t take their first RMD, the beneficiary must receive it immediately. As with the first rule, eligible beneficiaries have exceptions.

The Eligible Designated Beneficiary Dies

If an eligible designated beneficiary dies, the inherited IRA goes to the successor beneficiary. The successor takes distributions according to the eligible designated beneficiary’s life expectancy. These distributions must empty the IRA by the 10th year after the eligible designated beneficiary dies, starting with the first full year.

How Are Inherited IRAs and RMDs Taxed?

Inheriting a traditional IRA means paying standard income tax rates on distributions. Although the IRA income can raise your marginal tax rate, taking the distributions is better than the alternative: Failing to take RMDs incurs penalties as high as 50% of the annual RMD amount not taken.

On the other hand, Roth IRAs usually don’t raise your income taxes. Because the original account holder paid income taxes before contributing to the plan, withdrawals from Roth IRAs are tax-free, with one exception. If the Roth IRA was opened less than five years before the account holder passed away, the IRA’s earnings will incur income taxes unless you wait for the account to be five years old. Remember, their original contributions are still tax-free in these cases.

Consider talking to a fiduciary financial advisor to build an effective strategy for your inheritance or estate.

Proposed Regulations for Inherited IRAs

Because Secure 1.0 creates a thicket of rules and classifications to wade through, the IRS decided to waive missed RMD penalties for inherited IRAs from 2020 through 2024. However, industry experts expect that the federal government will provide definitive regulation in 2024 to clarify Secure 1.0. The waived penalties are a temporary measure to give beneficiaries time to prepare for the RMD rules that Secure 1.0 introduced.

Because the IRS has delayed enforcing RMD penalties for the last four years, 2024 may introduce new financial consequences for inherited IRA beneficiaries. As a result, consulting with tax professionals to navigate potential tax bills associated with RMDs in the coming years is recommended. Staying informed about legislative changes will help you make effective financial planning decisions.

Bottom Line

Inheriting an IRA often starts a 10-year clock on taking distributions. If a beneficiary falls into one of the exceptions, they can slow down distributions using their own life expectancy. The 10-year schedule for distributions increases your annual income from an inherited IRA, raising your taxes if the account is a traditional IRA. On the other hand, Roth Accounts provide tax-free status if the account is at least five years old.

Tips for 10-Year RMD Rules for Inherited IRAs

• Whether you inherit an IRA or win the lottery, a windfall can both create a giant financial cushion while worsening your tax situation. Understanding the implications of a lump sum or monthly distributions can help you optimize your finances and create a plan to secure your future. A financial advisor can draw up a customized financial pathway to reduce taxes and invest efficiently. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you’re not the sole beneficiary of an inherited IRA, the situation can get more complicated. Splitting an IRA between siblings can fray relationships, and navigating the process smoothly can help save money and stress.

• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.

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