Major inherited IRA mistakes and how to avoid them

[UNITED STATES] When someone inherits an Individual Retirement Account (IRA), it can feel like a financial windfall. However, the process of managing and distributing inherited IRA funds is filled with complex rules and regulations. Mistakes in handling inherited IRAs can lead to substantial tax penalties, missed opportunities for growth, and a diminished inheritance. Understanding common inherited IRA mistakes and learning how to avoid them can ensure you make the most of your inheritance.

1. Not Understanding the Tax Implications

One of the most significant inherited IRA mistakes is failing to understand the tax implications. Unlike other inheritances, IRAs come with specific tax rules that can affect how much of the windfall you actually keep.

The SECURE Act of 2019 changed many of the rules for beneficiaries, particularly eliminating the "stretch IRA" strategy for most beneficiaries. Now, many non-spouse beneficiaries are required to withdraw the entire inherited IRA balance within 10 years, subjecting them to tax on those distributions.

“The new 10-year rule is important to understand because it can cause your distributions to be taxed at higher rates, depending on your income in that year,” says financial expert.

Failing to plan for this can lead to an unexpected tax bill that could eat into your inheritance.

2. Ignoring the RMD (Required Minimum Distribution) Rules

Before the SECURE Act, beneficiaries who inherited an IRA had to take Required Minimum Distributions (RMDs) based on their life expectancy. However, with the SECURE Act's implementation, most non-spouse beneficiaries now face the 10-year rule, which eliminates the need for annual RMDs.

But this doesn’t mean you can wait until the end of the 10 years to make withdrawals. Many beneficiaries are unaware that they must still take distributions, and failing to do so could result in hefty penalties.

“While you don’t have to take annual RMDs anymore, taking no distribution at all is a huge mistake. If you don’t follow the withdrawal rules correctly, the IRS will impose a 50% penalty on the amount you should have withdrawn,” warns tax advisor.

3. Taking a Lump Sum Withdrawal

Taking a lump sum withdrawal might seem like an easy solution, but this could lead to a huge tax liability. When you withdraw all the funds from an inherited IRA in one year, the entire amount is added to your taxable income for that year, potentially pushing you into a higher tax bracket.

Instead, you should consider taking a more gradual distribution over time to avoid a sudden spike in your tax liability. This strategy can allow you to better manage your taxable income and avoid hefty penalties.

4. Failing to Name a Beneficiary

Inheriting an IRA without a beneficiary designation can complicate matters significantly. If the original IRA holder didn’t designate a beneficiary, the account might be subject to probate, which can delay the distribution and possibly result in the loss of tax advantages.

“Always ensure that the IRA holder names a beneficiary for their accounts,” says estate planning attorney. “It can prevent unnecessary complications and help ensure that the funds are distributed smoothly.”

5. Not Understanding Spousal vs. Non-Spousal IRA Inheritance Rules

One of the biggest mistakes a beneficiary can make is not fully understanding the difference between inheriting an IRA as a spouse versus as a non-spouse. Spouses have the option to treat the inherited IRA as their own, which allows them to avoid some of the required distributions for a period of time.

However, non-spouse beneficiaries must follow the new 10-year rule, and may face harsher tax consequences as a result. Failing to properly assess whether you're a spouse or non-spouse beneficiary can lead to tax surprises down the line.

6. Neglecting to Consult a Financial Professional

Inherited IRA rules can be complicated, and many beneficiaries fail to seek advice from financial or tax professionals who can guide them through the process. By not consulting with an advisor, you could make costly mistakes that could reduce your overall inheritance.

“Tax laws and IRA distribution rules are constantly evolving. It’s vital to stay informed and get personalized advice on how to manage an inherited IRA,” says certified financial planner.

7. Overlooking State Tax Rules

In addition to federal tax rules, state taxes may apply to inherited IRAs. Some states impose their own taxes on inherited retirement accounts, and not all states conform to federal tax rules regarding inherited IRAs.

“It’s easy to forget that state tax rules vary widely. Always consult your state’s tax laws to ensure you’re not caught off guard by unexpected state tax obligations,” recommends, a tax expert.

8. Using Inherited IRA Funds for Non-Retirement Expenses

It’s tempting to use the inherited IRA funds for non-retirement expenses, especially if you’re facing a financial hardship or have an urgent need for cash. However, this is a common mistake that can have severe tax consequences.

In most cases, IRA funds should be used for their intended purpose: retirement. While it’s possible to withdraw the funds for other purposes, you’ll have to pay taxes on them, and if you’re under the age of 59½, you could also face early withdrawal penalties.

9. Not Monitoring Your Inherited IRA Investments

Once you inherit an IRA, you inherit the investment choices made by the original account holder. Over time, these investments may not align with your risk tolerance or financial goals. It’s crucial to regularly review the IRA’s portfolio to make sure it matches your needs and objectives.

“Just because the account owner chose certain investments doesn’t mean they are the right choice for you,” says investment advisor. “Reviewing the portfolio and making changes as necessary can ensure that the inherited IRA is working in your favor.”

10. Underestimating the Impact of the 10-Year Rule

One of the most significant changes brought on by the SECURE Act is the 10-year distribution rule for non-spouse beneficiaries. This rule forces most beneficiaries to empty the inherited IRA within 10 years, but it doesn’t specify how to withdraw the funds within that timeframe.

While the rule offers flexibility, many beneficiaries make the mistake of waiting too long to take distributions, only to find themselves with a large tax bill. “Don’t procrastinate—plan out your withdrawals carefully to avoid a large tax hit down the road,” advises a tax expert.

Inherited IRAs can offer significant financial benefits, but managing them requires careful planning and a good understanding of the rules. By avoiding these common mistakes—understanding the tax implications, following RMD requirements, consulting a financial advisor, and avoiding lump sum withdrawals—you can make the most of your inheritance. Keep in mind that tax rules and inheritance laws may change over time, so staying informed is key. By following the best practices outlined in this article, you can avoid costly errors and ensure that your inherited IRA grows and supports your long-term financial goals.