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Inheriting an IRA these days comes with more headaches and financial complications than it did a few years ago.
In fact, how to best manage both withdrawals and the tax hit on an inherited IRA remains a hot — and somewhat confusing — personal finance topic seven months after the IRS proposed new rules.
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First, some background. Before the SECURE Act of 2019 changed the rules, beneficiaries who inherited an IRA could spread their withdrawals, or required minimum distributions (RMDs), out over their lifetime. The so-called “stretch IRA” meant tinier distributions and lower tax payments along the way, as payouts from traditional IRAs are taxed the same as wage income. Spreading required withdrawals over one’s lifetime also meant more time for beneficiaries to let their inherited IRA assets grow tax-free.
But the SECURE Act did away with the lifetime distribution period for most beneficiaries (who aren’t your spouse) if the IRA owner died on or after Jan. 1, 2020. Instead, the new law applies a “10-year (payout) rule” to both traditional and Roth IRAs, and simply requires beneficiaries to withdraw the full balance of an inherited IRA within 10 years.
But in February, the IRS went a step further. It proposed a new rule that requires beneficiaries of traditional IRAs (who aren’t your spouse) to take distributions each year during the 10-year period and a final distribution to zero out the account at the end of the 10th year following the original IRA owner’s death, provided the deceased owner was already required to take RMDs. “That is a far more accelerated approach to taking money out,” said Sham Ganglani, director of wealth management experience and retirement at Fidelity Investments. Under the new proposal, he added, “you can’t sit on the money for 10 years anymore and take out a lump sum” at the end.
Calculating the size of the annual distributions depends on the IRA balance and the age of the beneficiary, which adds a layer of complexity. This proposed change means many Americans who inherit traditional IRAs could end up paying more in taxes, especially if withdrawals in any year push them into a higher tax bracket. (Inherited Roth IRA owners don’t have to take distributions every year, but they do have to withdraw all the funds by the end of 10 years.)