Beginning in 2025, there’s been a bit of a change to how inherited individual retirement accounts (IRAs) are done. For anyone in the position of having to oversee one, they need to know these changes, as the Internal Revenue Service (IRS) could let some excessive penalties come their way that could jeopardize your financial health.
For IRAs inherited, one can split them into two groups: spouses and non-spouses.
Rules regarding inherited IRAs for non-spouses
Every year after the owner of the account dies, their heir must carry on making yearly withdrawals if the original owner has reached the age where Required Minimum Distributions (RMDs) are compulsory. In this case, if the original owner didn’t reach the age for taking RMDs, then this rule may not apply, but heirs should still plan to take these RMDs as quickly as possible.
According to Joel Dickson, global head of advice methodology at Vanguard, “This is about multi-year tax planning on an inherited IRA to take advantage of those benefits.”
Now is especially the time because, after the Secure Act of 2019, inheriting an IRA no longer comes with that extra tax benefit that allowed beneficiaries to ‘stretch’ their withdrawals over their lifetime. If an account you inherited was taken from a deceased person after 2020 and you’re not one of their spouses, you’re not a minor child, you’re not disabled or you’re not chronically ill, and you’re not the beneficiary of certain trusts, you very likely fall within the “10-year rule.” This rule requires that you have 10 years from the date the original owner dies to fully empty the inherited IRA.
The rule was unclear, and many people felt as long as there was nothing in the account by year 10, you don’t have to take RMDs, and the IRS opted to waive penalties a few years ago to make sure the rule was clear and no one got penalized unfairly, but the penalties are coming back on in 2025.
The rule kicks in 2025. Your heir will continue the yearly withdrawals so that the account is depleted in 10 years if the original account holder met the age when RMDs were required. You’ll pay a 25% penalty if you miss a required RMD or don’t withdraw enough. Fortunately, if you catch the error within two years from the time it is reported on your return, you can still pay 10 percent of the unused portion under penalty of perjury, as noted by the IRS.
Consider ‘strategic distributions’
For those facing the 10-year rule, spreading your withdrawals out evenly over 10 years will lower your tax bill, in line with Vanguard’s research from June that indicates that that works for most heirs. However, this is not the only way to dictate your new tax circumstances.
It starts, says Certified Financial Planner Judson Meinhart, director of financial planning at Modera Wealth Management in Winston-Salem, North Carolina, with ‘strategic distributions,’ as ‘you have to understand your current marginal tax rate and how that might vary over a 10-year period’.
Just as an example, say you’re anticipating having years of lower income, say from unemployment or for the early years of retirement, before you begin drawing from Social Security. It could make sense to run down acquired IRA funds during those years.
As such, you have to think about the negatives of this strategy: If you beef up your usual income with this, those may include losing your eligibility for college financial aid, changing student loan repayment terms if you’re on an income-driven plan, or increasing your Medicare premiums when you’re retired.
FAQs
Q. What changes will take effect regarding inherited IRAs in 2025?
A. Beginning in 2025, beneficiaries of inherited IRAs will be subject to new rules that require them to make yearly withdrawals if the original account owner reached the age for Required Minimum Distributions (RMDs). If the original owner did not reach that age, heirs should still consider taking RMDs as soon as possible to avoid penalties.
Q. What is the “10-year rule” for inherited IRAs?
A. The “10-year rule” requires that non-spouse beneficiaries must fully withdraw the inherited IRA within 10 years from the date of the original owner’s death if the account was inherited after 2020. This rule applies unless the beneficiary is a minor child, disabled, chronically ill, or a beneficiary of certain trusts.
Q. What penalties are associated with missing RMDs from inherited IRAs?
A. Starting in 2025, if a beneficiary fails to take the required minimum distributions (RMDs) or does not withdraw enough, a 25% penalty may be imposed on the amount that should have been withdrawn. However, if the error is corrected within two years, the penalty can be reduced to 10%.
Q. How can beneficiaries manage taxes when withdrawing from inherited IRAs?
A. Beneficiaries can engage in “strategic distributions” by planning their withdrawals over the 10-year period to minimize their tax burden. This involves understanding their current marginal tax rate and anticipating any changes in income, which can influence the timing and amount of withdrawals.
Q. What should beneficiaries consider when planning withdrawals from inherited IRAs?
A. Beneficiaries should consider their overall financial situation, including potential impacts on eligibility for college financial aid, changes to student loan repayment terms, and increased Medicare premiums. Planning withdrawals during years of lower income may help mitigate tax implications.