Experts warn that if you inherited a pretax individual retirement account after 2020, you could face a significant tax charge if you don't plan ahead of time. Previously, heirs may withdraw inherited IRA funds over their lifetime, known as the "stretch IRA."
However, the Secure Act of 2019 established the "10-year rule," which requires certain heirs, including adult children, to drain inherited IRAs by the tenth year following the original account owner's death.
The implementation of the 10-year rule has sparked considerable debate among financial advisors and tax experts. Many argue that this change could potentially disrupt long-term financial planning strategies for beneficiaries, especially those who were counting on the ability to stretch distributions over their lifetime. Critics of the rule suggest that it may force beneficiaries to take larger distributions than they would prefer, potentially pushing them into higher tax brackets and reducing the overall value of their inheritance.
However, waiting until the tenth year to withdraw from an IRA "could mean sitting on a tax bomb," according to certified financial adviser Ben Smith, founder of Cove Financial Planning in Milwaukee.
Pretax IRA withdrawals are subject to ordinary income taxes. The 10-year rule may result in higher annual taxes for certain heirs, notably those with higher incomes and larger IRA balances.
Experts warn that shortening the 10-year withdrawal window may exacerbate the problem.
Larger withdrawals might dramatically increase your adjusted gross income, potentially leading to higher capital gains tax rates or phaseouts of other tax benefits, according to Smith.
Smith, for example, has seen people lose their eligibility for the electric vehicle tax credit, which is worth up to $7,500, by withdrawing a big amount from an inherited IRA in one year.
Financial planners are increasingly advising their clients to consider a strategic approach to withdrawals from inherited IRAs. This may involve carefully timing distributions to coincide with years of lower income or increased deductions. Some experts suggest that beneficiaries should work closely with tax professionals to model various withdrawal scenarios and their potential tax implications. This proactive approach can help minimize the overall tax burden and preserve more of the inherited wealth.
Required withdrawals from inherited IRAs.
Since 2019, there has been debate about whether certain heirs were required to take yearly withdrawals, known as required minimum distributions, or RMDs, during the 10-year period.
Following years of waived fines, the IRS clarified RMD guidelines for inherited IRAs in July.
Beginning in 2025, some beneficiaries – heirs who are not a spouse, minor child, disabled, chronically sick, or beneficiaries of certain trusts — must begin drawing annual RMDs from inherited IRAs. The RMD rule applies if the original account owner achieved the RMD age, or "required beginning date," prior to death.
Starting in 2020, the Secure Act increased the starting age for RMDs from 70½ to 72. However, Secure 2.0 enacted two increases: RMDs commencing at age 73 in 2023 and age 75 in 2033.
The changes in RMD rules have created a complex landscape for retirement planning. Financial advisors are now emphasizing the importance of regular reviews and updates to estate plans. This is particularly crucial for individuals with significant IRA assets who want to ensure their beneficiaries are well-prepared for the tax implications of their inheritance. Some experts are also exploring alternative strategies, such as Roth IRA conversions or the use of charitable remainder trusts, to potentially mitigate the impact of the 10-year rule on beneficiaries.
IRA withdrawals are 'a matter of time'
Even if RMDs are not needed, experts advise heirs to stretch out their inherited IRA withdrawals.
"If you decide not to take a distribution from an inherited IRA in a year and it continues to grow, the tax bill increases right along with it," says CFP Carl Holubowich, principal at Armstrong, Fleming & Moore in Washington, D.C. "That money will be taxed at some point, it's just a matter of timing."
Experts suggest that some heirs may explore larger inherited IRA distributions in lower-income years during the 10-year window, as well as other tax-planning measures.
The concept of timing distributions strategically has gained traction among financial planners. Some are advocating for a "bracket-filling" approach, where beneficiaries take distributions each year up to the top of their current tax bracket. This method aims to avoid a large tax hit in the final year while also taking advantage of lower tax rates. Additionally, some advisors are recommending that beneficiaries consider using inherited IRA distributions to fund other tax-advantaged accounts, such as Roth IRAs or Health Savings Accounts, as part of a comprehensive tax management strategy.
Future income tax brackets.
Individuals may also think about future federal income tax brackets, IRA specialist and certified public accountant Ed Slott previously told the reporters.
Without modifications from Congress, hundreds of individual tax measures, including reduced federal income tax brackets, will expire after 2025. That would result in rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
"Every year you don't use [the lower brackets] is a wasted opportunity," Slott told the crowd.
However, with power of the White House and Congress uncertain, it is difficult to forecast if federal tax rates will alter after 2025.
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