Americans hold more than $19.2 trillion in IRAs (individual retirement accounts). So it’s likely you’ll end up inheriting one. And that’s definitely good news.
The catch: In most cases, you have to completely empty the account within ten years. And depending on the type of IRA and what kind of beneficiary you are (more on that in a minute), you could end up dealing with a much bigger current tax bill than expected.
But, still, this windfall can help boost your net worth and your cash flow. And when you know how to manage it, you can maximize both and minimize any possible tax bill.
Your Beneficiary Relationship Matters
Unless you fit into a very narrow beneficiary description, you’ll have just ten years to drain the account. The rules depend on who you are in relation to the person who left you the IRA. And they can seem complicated.
The main categories include:
- Eligible designated beneficiaries
- Designated beneficiaries
- Non-designated beneficiaries
Generally speaking, a designated beneficiary is someone listed as a beneficiary on an IRA account – someone who will inherit the account when the owner dies. Designated beneficiaries can be either eligible or not.
Here’s a more detailed look at the three categories.
Eligible Designated Beneficiaries
Eligible designated beneficiaries are a special group subject to different, more advantageous rules when it comes inherited IRAs. People who fall into this category don’t have to drain the full account within ten years, giving them more flexible planning and tax options.
This group includes:
- Surviving spouses
- Minor children
- A person in the same basic age group as the original owner, like a sibling or friend, specifically someone who’s older than or not more than ten years younger than the original owner
- Disabled or chronically ill people (based on the legal IRS definition)
Eligible designated beneficiaries can withdraw the IRA funds over their own lifetime. That stretching ability makes it easier to manage withdrawals and minimize any tax consequences of the inheritance.
There is one exception: As soon as a minor child beneficiary turns 18, they turn into a designated beneficiary (no longer eligible) who has to follow the ten-year rule.
Designated Beneficiaries
This category lumps in everyone who’s an officially named beneficiary on the original owner’s IRA who doesn’t fall into any of the eligible categories. It includes adult children, nieces and nephews, and anyone else more than ten years younger than the decedent.
Non-designated Beneficiaries
When an IRA owner hasn’t designated a beneficiary, the account typically becomes part of the decedent’s estate and has to go through probate. Other times, a non-designated beneficiary could be a trust or a charitable organization. Generally, any non-person would count as a non-designated beneficiary and these entities are subject to different rules.
Since we’re all people here, we’re going to focus on the rules for eligible designated and designated beneficiaries. And we’re going to start with the ten-year rule.
The Ten-Year Rule
Designated beneficiaries have to withdraw every dollar from an Inherited IRA within ten years. That ten-year timeline starts the year after the original owner’s death and ends on December 31 ten years later. For example, if someone died in 2026 and left you an IRA, you would have until December 31, 2037 to withdraw all the money. This covers traditional and Roth Inherited IRAs.
Remember, eligible designated beneficiaries aren’t bound by the ten-year rule. And the most common type of EDBs is spouses.
A Spouse’s Guide to Managing an Inherited IRA
Spouses have the most flexibility when it comes to inherited IRAs. If this is your situation, you have 3 basic options to choose from:
- Move the funds into an Inherited IRA (also called a beneficiary IRA). This can work well if you’re younger than 59½ and will need the money before then. The money you take out won’t be subject to the 10% early withdrawal penalty, which would happen if it were in a regular traditional IRA. You will have to take RMDs (required minimum distributions) based on your life
expectancy, but can delay them until the year your spouse would have turned 73 or December 31 of the year after their death, whichever is later. If the original IRA was a Roth, your inherited IRA will also be a Roth and you won’t need to take RMDs. - Transfer it into your own IRA. This method acts as if the IRA were yours the whole time. With a traditional IRA, you’ll need to start taking RMDs when you reach age 73 (or age 75 starting in 2033). This option lets you convert all or a portion of a traditional IRA to a Roth IRA, so the money grows tax-free without any RMD drag. If the Inherited IRA is already a Roth, you can just let it grow until whenever you’re ready to take tax-free withdrawals.
- Take a lump-sum distribution. Cashing out the full inherited IRA may make sense depending on your specific situation. This is generally considered to be the least beneficial option as it can trigger an enormous immediate tax bill. But in some circumstances, this could be your best choice. This depends on your current income and tax situation, the amount of money in the Inherited IRA, and your personal financial goals – like starting your own business or buying a house. If it’s a traditional IRA, you will have a large tax bill. If it’s a Roth IRA, your withdrawals will be tax-free if the account had been open for five years or more, otherwise the account earnings – but not the account contributions – will be taxable.
If You’re a Non-Spouse Beneficiary
When you aren’t an eligible designated beneficiary, you have two options:
- open an Inherited IRA and withdraw the full balance within ten years or
- take a lump-sum distribution
With a traditional Inherited IRA, you’ll pay income taxes – but no early withdrawal penalties – on the money as you withdraw it. If the person you inherited from was already taking RMDs, you will need to continue taking them. If not, you can leave the money sitting there until time is up or make withdrawals of any amount whenever you want. Regardless of whether you have to take RMDS, the inherited IRA account must be emptied by the end of year ten.
With a Roth Inherited IRA, you won’t have to take any RMDs – so you’re free to leave the money in the account and let it grow until the last possible minute. If the original account had been open for at least five years, all of your withdrawals will be tax-free. If not, account earnings – but not contributions made by the original owner – may be taxed.
Should I Keep the Same Investments in the Inherited IRA?
If you’re a spouse beneficiary, you may have made your retirement account investment decisions as a couple. Even so, you’ll want to make sure the portfolio still works for your new situation. Unless you decide to take a lump-sum distribution and use the money for something else, review your personal financial situation and goals before you choose individual investments for the account.
If you’re a non-spouse eligible designated beneficiary who’s near the same age as the original owner, their investments may also make sense for you – but may not. The timeline is similar but you may have a different risk tolerance and different financial goals that call for different investments.
If you’re a designated beneficiary, you may be substantially younger than the original IRA owner. So their investment profile will almost certainly not match yours. Even with the shortened ten-year timeline, you should still choose investments that match your plans and priorities rather than defaulting to the same portfolio that already existed.
You Inherited an IRA – Now What?
Feeling unsure of your beneficiary designation? Confused about how to complete the inherited IRA paperwork? Still working on setting financial goals and priorities? Unclear on your true risk tolerance?
I can help with that.
During a personal financial coaching session, you and I can sit down to review:
- Your current and future goals
- What do you want the money to do
- Your current situation
Then together, we’ll analyze the investments you already have, as well as this inherited IRA to figure out the best ways for you to use this inheritance.
One caveat: As a CPA, I cannot recommend specific investments.
I can help you figure out how this inheritance will fit into your overall financial plan, discuss the tax consequences of each option you want to consider, and help you set goals to make all of this work in your favor. I can also recommend financial advisors that you can consult, once you and I have a plan in place.
These personal financial coaching sessions are designed to make you comfortable with your financial situation and to help you understand what’s going on, so you can make the best decisions for your current and future life.
A single session is $250 and we can get a lot done in that time. Depending on your situation, one session may be all you need to get everything involving your inherited IRA settled and working for you.
Click on the button below to schedule your personal financial coaching session now.