Inheriting an IRA

If you’ve inherited an IRA, you may be aware that the distribution rules are different from regular IRAs and were changed when the SECURE Act was passed into law in 2019. I’ll explain.

First, note that as with other IRAs — Roths are distributed tax-free and pre-tax IRA distributions are taxed as ordinary income.

Pre-2020 Inheritance

If you inherited an IRA before 2020, generally, you were subject to required minimum distributions (RMDs) each year, based on your age and lasting for your lifetime. This was true for both Roth and pre-tax IRAs. These rules remain in effect with the SECURE Act and you can continue to take RMDs based on this schedule.

2020 Inheritances and Beyond

If you inherited an IRA in 2020, you should be aware of the new 10-year rule that was instituted with the SECURE Act. With few exceptions (most notably inheriting your spouse’s IRA), you are no longer subject to RMDs but you must empty the account in 10 years. This is true for both Roth and pre-tax inherited IRAs.

Distribution Strategies

For inherited Roth IRAs, the optimal distribution strategy is simple — delay, if you can afford to do so. If you don’t need the money, leave it in the account and let it grow tax-free for 10 years; then distribute 100% of the account balance at the end of the 10th year.

For inherited pre-tax IRAs, the optimal distribution strategy is situation-dependent. Yes, you could wait for the 10-year period and then empty the entire account but you’ll likely be pushing yourself into a higher tax bracket for that year and you could end up paying more tax on this lump sum than you would have over the entire period. Similarly, you could distribute it all immediately but that would also likely subject you to more taxes than is necessary.

Instead, you’ll want to project out your income over 10 years, as best as you’re able. You’ll then want to take distributions in a manner that will minimize the total taxes you pay over the 10-year period. Easier said than done.

This is not so simple because you don’t know your future:

1. income
2. tax bracket
3. investment rate of return
4. state of residence (states tax IRAs differently, or not at all)

For example, here are four possible scenarios with different strategies:

1. If your future income is going to be consistent and comparable to the present, you might want to target a constant dollar amount that you distribute each year for the next 10 years.
2. If your income is low now but you expect it to be higher in the future, you may want to take a large distribution now and lower ones in future years.
3. If your income is high now but you expect to retire in a few years, you may want take no distributions until your retirement and then do a constant dollar amount until the 10-year period is up.
4. If you’re already retired but have not yet claimed Social Security or started RMDs from your regular IRA, you may want take large distributions until your Social Security and/or IRA RMDs begin.

There’s no single answer for everyone’s situation. If doing these projections don’t excite you, consider engaging in some tax planning guidance.  If your inherited pre-tax IRA is a significant amount, paying for this expertise could be well worth it in the tax savings that may result.

Inheritance from a Spouse

None of this applies if you inherited an IRA from your spouse. (There are a few other exceptions that I’ll ignore here.) Simply put, when you inherit an IRA from a spouse, you don’t have to treat it as an inherited IRA. Instead, you can roll it into your own IRA and be subject to the regular IRA rules, instead of the new 10-year distribution rules. In most situations, this is what you should do with a spousal IRA inheritance.

If you’ve inherited an IRA, share no more than is necessary with the IRS.