What beneficiaries should know about their Inherited IRA

Inheriting an individual retirement account (IRA) could be a potential windfall, but Inherited IRAs also come with certain requirements to withdraw money that could impact your taxes or lead to potential penalties.

Travis Huber, IRA product manager at Wells Fargo Wealth & Investment Management, Wells Fargo Clearing Services, LLC., answers questions we often hear from clients about Inherited IRAs, including providing tips on beneficiary options, required minimum distributions (RMDs), and tax considerations.

What is an Inherited IRA?

When a loved one with a tax-advantaged retirement account passes away, the account beneficiary must transfer the assets into a new account in the beneficiary’s name. This new account is known as an Inherited IRA or a Beneficiary IRA.

The Inherited IRA must be the same type of account as the original account. For example, if a loved one gifted you a Traditional IRA, you must transfer the assets to an Inherited Traditional IRA account.

Beneficiaries cannot make further contributions to an Inherited IRA. Instead, the account is used solely for the distribution of the inherited funds.

What can I do with an Inherited IRA?

You have three options to consider as the recipient of an Inherited IRA:

• Take a lump-sum distribution
• Take distributions in accordance with your beneficiary status (which may also be impacted by the original account holder’s age and status)
• Disclaim the gift altogether (meaning the IRA would pass to another beneficiary)

Huber strongly recommends that if you’re considering the last option, you engage an attorney before finalizing the decision. “When someone passes away and names you as beneficiary, don’t sign any type of account paperwork before deciding if you want to disclaim it,” he says. Huber also points out that disclaiming an Inherited IRA could have tax implications for any alternate beneficiaries, so it’s important to discuss such a plan with those involved ahead of time.

How could an Inherited IRA affect my taxes?

When you inherit an IRA, you may be required to withdraw a minimum amount from it each year. This amount is known as the required minimum distribution, or RMD. You may withdraw more than the minimum if you wish, but you must take at least the RMD annually.

“Since distributions from an Inherited Traditional IRA typically increase the beneficiary’s taxable income, it’s going to affect their tax situation,” Huber says. How much of an impact the RMD will have on your taxes depends on multiple factors, including the retirement account type, when the original IRA account holder died, and who is inheriting the account.”

You will want to discuss any potential impacts with your tax professional.

What is the 10-year rule?

Established by the 2019 SECURE Act, the 10-year rule requires certain beneficiaries of Inherited IRAs to withdraw all account funds within 10 years of the original account holder’s death.

Inherited IRA beneficiaries must take annual RMDs if the original account holder was old enough to take RMDs when they passed away (currently, RMDs kick in at age 73).

But if the original account holder wasn’t old enough for RMDs at the time of their passing, the beneficiary only needs to empty the account by December 31 of the 10th year following the original account holder’s death.

What if I’m a spouse who inherited an IRA?

Spouses have the most flexibility when it comes to managing an Inherited IRA and taking distributions. Generally, a spousal beneficiary can treat Inherited IRAs like their own, rolling the funds into their own retirement account and choosing distribution options based on their circumstances.

For example, you could let the account continue to grow until you reach age 73 and are required to take distributions. Depending on your financial needs and your tax situation, you could either take RMDs over the calculated life expectancy of your departed spouse or take RMDs under the 10-year rule.

What other types of Inherited IRA beneficiaries are there?

Eligible designated beneficiaries (EDBs) include spouses, children under the age of 21, people who are disabled or chronically ill, and people who are not more than 10 years younger than the original account holder. These beneficiaries have more options for managing an Inherited IRA and any RMDs. We recommend that such beneficiaries or their guardians seek professional advice.

Designated beneficiaries are individuals who don’t fall under the EDB category, such as adult children or non-relatives. Designated beneficiaries are typically subject to the 10-year rule only.

Nondesignated beneficiaries are nonperson entities, like estates, charities, or certain trusts. If the original holder of the IRA account dies before age 73 (as of 2023), a non-designated beneficiary must withdraw all funds by December 31 of the fifth year after the original account holder passes away.

How can I minimize taxes and penalties associated with an Inherited IRA?

Ideally, families should be talking about potential asset transfers well in advance and preparing for them. If an account holder doesn’t want to pass the tax burden to the beneficiary, the account holder might consider converting a Traditional IRA to a Roth IRA. Since Roth IRA contributions are made with after-tax income, distributions from the account are tax-free.

Making qualified charitable distributions can also help Inherited IRA beneficiaries offset taxes. If the beneficiary is 70½ or older, the individual can distribute directly from the IRA to a charitable organization, which can help fund their philanthropic giving and minimize taxes.

For many people who inherit an IRA, trying to avoid taxes altogether may be impractical. That’s when Huber says a trusted advisor can be a big help: “Work with a financial advisor or tax professional to determine the best way forward for you and your family.”