The advent of 401(k) plans in the early 1980s marked a significant shift in retirement savings. With the Baby Boomer generation now entering their golden years, a substantial transfer of wealth is on the horizon. A key component of this transfer involves inherited IRAs, and the rules governing these accounts have undergone considerable changes in recent years.

Inherited IRAs are retirement accounts passed down from a deceased individual to a beneficiary. Due to their tax-deferred nature and potential for substantial value, careful management is essential. Traditionally, beneficiaries were required to withdraw funds based on their life expectancy, allowing for a gradual distribution and tax burden.

In 2019, Congress passed a new law called the SECURE Act, which changed the rules around the tax treatment and requirements for inherited IRAs. The main difference here as it applies to inherited IRAs is that instead of stretching the distributions over your lifetime, everyone was required to take out all of the money over a 10-year period. Those who had an inherited IRA prior to that time still follows the old rules, but the new rule was you had to take it out over 10 years.

As is often the case with tax laws, Congress frequently passes legislation without providing specific implementation details. The IRS is then tasked with creating regulations to clarify the law’s requirements.

Following the SECURE Act, tax professionals and financial advisors adjusted their guidance for clients inheriting retirement funds. Initially, it was understood that beneficiaries could withdraw any amount each year, as long as the entire account was depleted within 10 years. This interpretation led to various financial planning strategies.

For some who were in the peak of their earning years, it would make sense to hold off until later years, assuming they were going to retire and then they could take bigger chunks in those future years and pay lower taxes because they were in a lower tax bracket. For example, if someone makes $200,000 per year and they withdraw $100,000 from the inherited IRA, they are likely paying 24% tax on that money. If they wait until the year they retire, then that $100,000 (assuming no salary), would have them in the 12% or 22% tax bracket. It could be wise to wait in that situation. On the other hand, if the amount inherited was $100,000 and the person expects to make more money or believes tax rates will go up, then deferring until year 9 or 10 might make sense.

About a year later, the IRS came out and said they didn’t believe that Congress meant for it to be that straightforward and flexible. Their interpretation was not that you can just wait and take it out any year you want, but rather you would need to take it out ratably. Soon thereafter they changed their opinion and said they thought that it should be that if the person who passed was already taking required minimum distributions, then the beneficiary who received the money should be required to continue those RMDs, at a minimum.

Because there was confusion and the IRS had continued to receive feedback from the public for a few years, they continued to put off the requirement to take the RMDs. In other words, they weren’t going to penalize people who hadn’t taken money out.

In June, the IRS finalized the rules around inherited IRAs. They made it clear that, starting in 2025, if the person you inherited the IRA from had to take RMDs before they passed, then you must take the RMD that they would have taken when they were alive.

Exceptions

Like most rules, there are exceptions to this one as well. If you are the spouse of the person who passed, you can simply roll their retirement funds into your retirement account, assuming they left you the money. Similarly, if you are a minor child, a person with certain disabilities or someone not more than 10 years younger than the person you inherited the account from, you can stick with the old rules.

The Key Takeaway

All of this can be confusing to the average person, so it is important to consult your financial advisor and tax professional if you have inherited an IRA in the last few years or if you end up inheriting one in the future. Tax penalties can be expensive if you make a mistake, so get the help you need. If you are looking for an advisor to help you, feel free to reach out.

(Disclaimer: This article is for informational purposes only and should not be considered tax, legal or investment advice. Consult a financial advisor with specific expertise who can help you with your individual situation.)