If you’ve postponed taking required distributions from an inherited individual retirement account (IRA), mark your calendar. There’s a good chance you’ll need to start taking withdrawals from your account next year to avoid a hefty penalty from the Internal Revenue Service (IRS).
Beneficiaries of traditional IRAs have always had to pay taxes on withdrawals from inherited accounts, but before 2020, they could minimize the tax bill by extending withdrawals over their life expectancy. The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was signed into law in 2019, put an end to this tax-saving strategy for most adult children, grandchildren and other non-spouse heirs who inherit a traditional IRA from someone who died on or after Jan. 1, 2020.
Those heirs now have two options: Take a lump sum and pay taxes on the entire amount or transfer the money to an inherited IRA that must be depleted within 10 years after the death of the original owner. For example, if you inherited an IRA in 2020, year one is 2021, and the account needs to be cleaned out by Dec. 31, 2030.
Initially, tax experts believed non-spouse beneficiaries could wait until year 10 to deplete their accounts, which would give beneficiaries more flexibility in how they time their withdrawals. But the IRS issued guidance in early 2022 stating that if the original owner died on or after the date he or she was to take required minimum distributions, non-spouse beneficiaries must take required minimum distributions (RMDs) based on their life expectancy in years one through nine and deplete the balance in year 10. (If the original owner hadn’t started RMDs, beneficiaries can take withdrawals anytime during the 10-year period.)
In response to confusion about that guidance, the IRS waived penalties for failing to take an RMD from an inherited IRA in tax years 2021 through 2024. However, the IRS issued final rules in July stating that beneficiaries must start taking RMDs next year and deplete the account within 10 years of the original owner’s death. The penalty for missing a distribution is 25 percent of the amount you should have withdrawn. (The penalty will be reduced to 10 percent if you make up the missed RMD within two years.)
The 10-year rule also applies to inherited Roth IRAs, but with an important difference: You aren’t required to pay taxes on the withdrawals, and you don’t have to take required minimum distributions because the original owner didn’t have to take them, either. If you can afford to wait until year 10 to deplete the account, you’ll enjoy more than a decade of tax-free growth.
The 10-year rule doesn’t apply to spouses who inherit an IRA. They’ll continue to have the option of rolling the money into a new or existing IRA and postponing withdrawals until they reach the age at which they must take RMDs (currently age 73). Still, the requirement will affect millions of Generation X, millennial and Gen Z adult children who stand to inherit trillions of dollars in IRAs and other assets from their parents over the next 20 years.
