Dear Savvy Senior, What are the rules regarding inherited IRAs? When my mom died this year, I inherited her traditional IRA and would like to know what I need to do to execute it properly. — Confused Daughter
Dear Confused, I’m very sorry about the loss of you mother. Inheriting an IRA from a parent has a unique set of rules you need to know, which will help you make the most of the money you inherit and avoid a tax-time surprise. Here are some basics you should know.
Set-up inherited account
Many people think they can roll an inherited IRA into their own IRA. But if you inherit an IRA from a parent, aunt, uncle, sibling or friend, you cannot roll the account into your own IRA or treat the IRA as your own. Instead, you’ll have to transfer your portion of the assets into a new IRA set up and formally named as an inherited IRA — for example, (name of deceased owner) for the benefit of (your name).
If your mom’s IRA account has multiple beneficiaries, it can be split into separate accounts for each beneficiary. Splitting an account allows each beneficiary to treat their own inherited portion as if they were the sole beneficiary.
You can set up an inherited IRA with most any bank or brokerage firm. However, the easiest option might be to open your inherited IRA with the firm that held your mom’s account.
10-year withdrawal rule
Because of the Secure Act, which was signed into law in December 2019, most (but not all) IRA beneficiaries must deplete an inherited IRA within 10 years of the account owner’s death. This applies to inherited IRAs if the owner died after Dec. 31, 2019.
There’s no limit on when or how often you withdraw money from the account, as long as the account is empty by the end of the 10 years. That is, you can choose to withdraw all of the money at once, you can leave it sitting there for a decade and then take it all out, or you can withdraw distributions during time. Be aware with a traditional IRA, each withdrawal will be counted as income and subject to taxes in the year you make the withdrawal.
Exceptions to the rule
There are several exceptions to the IRA 10-year rule, including for a surviving spouse, minor child, disabled or chronically ill beneficiary, or a beneficiary who is within 10 years of age of the original IRA owner. These beneficiaries might be able to receive more time to draw down the account and pay the resulting tax bill.
For example, when you inherit an IRA from a spouse, you can transfer the IRA balance into your own account and delay distributions until after you turn 72.
Minor children must start required minimum distributions from an inherited IRA but don’t become subject to the 10-year rule until they reach the “age of majority,” which is 18 in most states. Disabled and chronically ill beneficiaries, and those within 10 years of age of the original account owner, have the option to stretch required withdrawals during their lifetime.
Minimize your taxes
As tempting as it might be to cash out an inherited IRA in a lump-sum withdrawal, tread carefully. This option could leave you owing a hefty sum when it’s time to file your taxes. Withdrawals from a traditional IRA generally are taxable as income, at your income tax rate.
For some people, it can be a smart tax move to gradually draw down the account during the 10-year period to avoid a large tax bill in a single year and potentially being bumped into a high tax bracket. Or, if you’re approaching retirement, say in five years, you might want to wait to start withdrawing from the account until you are retired and your income drops, potentially putting you into a lower tax bracket.