Inheriting an individual retirement account (IRA) can be a blessing, providing financial security and stability for the future. However, with the passage of the Secure Act in 2019, inherited IRA owners now face new challenges when it comes to managing their tax liabilities. The “10-year rule” introduced by the Secure Act requires certain heirs to deplete their inherited IRAs within a 10-year window, potentially leading to significant tax implications if not handled strategically.
The Impact of the 10-Year Rule on Inherited IRA Owners
Prior to the enactment of the Secure Act, heirs had the option to take withdrawals from inherited IRAs over their lifetime, commonly referred to as the “stretch IRA” strategy. This allowed for more flexibility in managing tax obligations and maximizing the benefits of the inherited account. However, with the introduction of the 10-year rule, heirs, including adult children, are now required to withdraw the funds within a shorter timeframe, potentially resulting in higher tax liabilities.
Certified financial planner Ben Smith, founder of Cove Financial Planning in Milwaukee, warns that waiting until the 10th year to make IRA withdrawals could result in a “tax bomb” for inherited IRA owners. Pre-tax IRA withdrawals are subject to regular income taxes, and the compressed withdrawal timeline under the 10-year rule can lead to larger yearly tax bills, especially for higher earners with substantial IRA balances.
Shortening the withdrawal window to just 10 years can exacerbate the tax consequences for inherited IRA owners. Larger withdrawals within a shorter timeframe can significantly increase adjusted gross income, potentially triggering higher capital gains tax rates or phaseouts for other tax benefits. For example, taking a substantial inherited IRA withdrawal in a single year could cause individuals to lose eligibility for valuable tax credits, such as the electric vehicle tax credit.
Understanding Required Minimum Distributions for Inherited IRAs
In the wake of the Secure Act, there has been confusion surrounding whether certain heirs are required to take yearly withdrawals, known as required minimum distributions (RMDs), from inherited IRAs during the 10-year period. After years of uncertainty, the IRS finalized RMD rules for inherited IRAs in July, providing clarity for beneficiaries.
Starting in 2025, certain heirs who are not spouses, minor children, disabled, chronically ill, or certain trusts must begin taking yearly RMDs from inherited IRAs. The RMD rule applies if the original account owner reached their RMD age before death. With the Secure Act raising the required beginning date for RMDs to age 72 from 70½, heirs need to be aware of the timing and implications of these mandatory distributions.
Furthermore, the Secure Act 2.0 introduced additional changes to RMDs, with the age for beginning distributions increasing to 73 in 2023 and 75 in 2033. These adjustments underscore the importance of proper planning and understanding the implications of RMDs for inherited IRA owners.
Strategies for Managing Inherited IRA Withdrawals
Despite the challenges posed by the 10-year rule and RMD requirements, inherited IRA owners have options for managing their tax liabilities and maximizing the benefits of their inherited accounts. Financial experts recommend spreading out withdrawals over the 10-year period to avoid a lump-sum tax hit and potentially lower overall tax liabilities.
CFP Carl Holubowich, principal at Armstrong, Fleming & Moore in Washington, D.C., emphasizes the importance of timing when it comes to IRA withdrawals. By strategically planning distributions from an inherited IRA, individuals can minimize their tax burden and make the most of their inherited assets. Holubowich advises that the tax on IRA withdrawals will need to be paid at some point, and careful planning can help mitigate the impact on an individual’s financial situation.
In addition to spreading out withdrawals, some heirs may consider taking larger distributions in lower-income years to minimize tax implications or explore other tax planning strategies. Understanding future federal income tax brackets and potential changes in tax rates can also inform decisions around inherited IRA withdrawals and overall tax planning strategies.
IRA expert and certified public accountant Ed Slott highlights the importance of utilizing lower federal income tax brackets before they sunset after 2025. By taking advantage of these lower rates, inherited IRA owners can potentially reduce their tax liabilities and optimize their financial outcomes. However, with uncertainties surrounding future tax policies, it’s essential for individuals to stay informed and adapt their strategies accordingly.
In conclusion, inheriting an IRA comes with its own set of challenges, particularly in light of the 10-year rule and RMD requirements introduced by the Secure Act. By understanding the implications of these regulations, planning strategically, and seeking guidance from financial experts, inherited IRA owners can navigate the complexities of managing their tax liabilities and make informed decisions to secure their financial future.