Is Your Inherited IRA a Tax Bomb Waiting to Blow

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Is Your Inherited IRA a Tax Bomb Waiting to Blow?

September 18, 2024

Working individual retirement accounts (IRA) into your legacy plans has gotten a bit trickier post-2020, leaving your heirs with a potentially sizable tax bill without proper planning.

Previously, heirs could take withdrawals from inherited IRAs over their lifetime, in what were known as "stretch IRAs." However, as part of the SECURE Act of 2019, inherited IRAs are now subject to the "10-year rule," which requires that most heirs deplete the inherited IRA by the 10th year after the original account owner's passing.

Waiting until that 10-year mark to drain the inherited IRA could have massive tax implications. Withdrawals from traditional (non-Roth) IRAs incur regular income taxes, meaning a large tax bill during the 10th year, especially if the balance had been left to grow for the entirety of the 10-year period.

Even taking regular withdrawals throughout the 10-year period may have tax implications too. As inherited IRA withdrawals push adjusted gross income higher, heirs may face higher capital gains rates or phaseouts for other tax benefits like credits and educational aid.

Recent rulings from the IRS also give your heirs less flexibility with withdrawals from inherited IRAs. Previously, heirs could be tactical with their withdrawals, taking distributions in years when their income was lower and the tax impact would be muted. Beginning in 2025, however, most heirs-those who are not spouses, minors, or disabled/chronically ill-will have to take yearly required minimum distributions (RMDs) from their inherited IRAs. The RMD rule applies if the original account owner reached the age when RMDs begin before passing.

As the name implies, individual retirement accounts were designed primarily as a means to support retirement planning. By their nature, they are not particularly efficient ways to leave money to future generations, and the recent changes under the SECURE Act and subsequent IRS rulings have made them even more potentially difficult for your heirs to navigate without incurring unnecessary taxation. If you have a sizable IRA and wish to leave it to your heirs, one possibility would be to consider a Roth conversion. While your heirs will still have to abide by the 10-year rule, distributions from Roth IRAs are tax-free. If you are interested in more tax-efficient ways to leave a legacy to your heirs, or have an inherited IRA that you need assistance dealing with, please contact our financial planning team today.

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