What to Do With an Inherited IRA

While the new rules for inherited IRAs sound a little wonky, it’s important that you wrap your head around the changes, said Ganglani. Why? “So you can keep as much of the money as possible and avoid a penalty,” Ganglani said. “In order to get the best outcome, you need to know what the rules are.”

The IRS has not yet issued final rules, but the proposed regulations serve as its take on the law. The new IRS guideline also could penalize taxpayers who inherited traditional IRAs after 2019 but didn’t take required annual distributions. The penalty is equal to half of the amount that should have been taken out. For example, if the minimum annual distribution is $20,000 and you don’t take it, the IRS penalty is $10,000. “It gets really expensive if you don’t properly manage required minimum distributions,” said Brad Bernstein, managing director and senior portfolio manager at UBS Wealth Management.

To avoid potential penalties before a final IRS decision, many financial planners recommend that nonspouse beneficiaries go ahead and take the annual distribution. Some financial firms, though, are taking a wait-and-see approach and are awaiting final rules from the IRS before advising clients on next steps. If you inherited an IRA after 2019, it’s a good idea to check in with your accountant or financial advisor, experts say.

So, how should you play it? Here are some strategies that IRA beneficiaries can consider to maximize their IRA assets:

•  Spread withdrawals out over time. The new 10-year rule that requires most nonspouse beneficiaries to take annual RMDs isn’t necessary a bad thing — especially if the IRA you inherit has a sizable account balance. The reason: If you spread your withdrawals across many years, it will help you avoid large distributions that could push you into a higher tax bracket, which will boost your tax bill and reduce your after-tax return on the inherited IRA. “What do you keep after taxes? That is the key,” said Rob Williams, managing director of financial planning at Schwab Center for Financial Research. “That might mean a multiyear strategy to smooth out taxes over time.” 

The remaining dollars in the IRA will benefit from tax-free growth in future years. In contrast, if you opt to take your IRA inheritance in a lump sum, you’ll likely put yourself in a higher tax bracket, costing you money in higher taxes.

• Take a larger distribution in years when your taxable income is lower. Despite the term “10-year rule,” beneficiaries can actually spread their distributions across 11 tax years by taking a withdrawal in the year the original IRA owner died plus a distribution every year until the year of the 10th anniversary of the original owner’s death, according to investment firm UBS.

There are also ways to play it if the original owner of a traditional IRA dies before he or she was required to take RMDs. You can delay your distributions to extend the runway of tax-deferred growth on your inherited IRA assets. You can also opt to take a distribution to take advantage of a year where you earn less income.

Since Roth IRAs aren’t subject to RMDs and withdrawals are tax-free, it makes financial sense to let your Roth grow as long as possible while you’re taking withdrawals from your inherited IRA during the 10-year-rule period. “If you inherit a Roth, let it roll,” said Bernstein of UBS. “If you don’t need the money, let it grow tax-free for 11 years.”

When it comes to investing the money from an inherited IRA, financial professionals recommend treating the account balance as part of your overall asset mix. That means making sure that your overall holdings of stocks, bonds, cash and other assets are in line with your financial goals and risk tolerance, says Fidelity’s Ganglani. If you inherit an IRA that is 100 percent in cash, for example, you might want to diversify the money into other investments with greater growth potential, especially if you don’t need the money now. “People should ensure that they are getting the most out of [the inherited IRA] and that the money is working for them,” Ganglani said.

The bottom line: The IRS’s new rule to take distributions each year might be a plus, rather than letting your inherited IRA ride for 10 years before taking a lump sum.

“The new regulation forces that smoothing out, and in the end that might not be as bad a thing as it appears to be,” says Schwab’s Williams. “You won’t have a large lump sum and a large tax bill in the last year. Having flexibility is always better.”