New Inherited IRA Rules Mean Heirs Could Be Left With Large Tax Bills

Internal Revenue Service (IRS) building in Washington on June 28, 2023. Madalina Vasiliu/The Epoch Times

The IRS’s new rules on inherited IRA accounts may leave beneficiaries with large tax bills from next year if they do not fulfill withdrawal conditions set out by the agency.

An inherited IRA is an individual retirement account opened when a someone inherits an IRA plan, and assets are moved from the original owner’s IRA to the new account. Beneficiaries of such inherited IRAs have to pay taxes on these accounts. Before 2020, taxes could be minimized by beneficiaries through stretching out withdrawals across their estimated life expectancies.

However, in 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law, ending this tax-saving option for individuals with inherited IRAs.

The rules differ based on whether a person inherits a traditional or a Roth IRA. Individuals who have inherited a traditional IRA on or after Jan. 1, 2020 now have two options on how to use the money in the account.

They can either withdraw the full amount as a lump sum and pay taxes or transfer the funds into an inherited IRA that must be depleted within 10 years of the original owner’s death.

The SECURE Act also has rules on how the withdrawals from inherited IRAs must be conducted based on whether the original owner of the account began making the required minimum distribution (RMD) withdrawals or not. RMDs are the minimum amounts that IRA owners have to withdraw from accounts each year when they reach a certain age.

If the original owner of the IRA account died before they were required to take RMDs, the beneficiary can make withdrawals from the inherited account at any time for any amount provided the inherited IRA account is depleted by the 10th year.

But if the original owner died on or after the date they were required to make the RMD withdrawals, the beneficiary must take the RMDs between the first and the ninth year, depleting the account in the 10th year.

Beneficiaries who do not withdraw their RMDs as expected will be charged with a penalty equivalent to 25 percent of the amount they failed to withdraw. The penalty is reduced to 10 percent if the beneficiary makes the missed RMD withdrawals over the next two years.

Since the new rules are applicable after Jan. 1, 2020, individuals with inherited IRAs were expected to make RMDs in the following years. However, as the rules created confusion, the IRS waived penalties for tax years 2021 and 2022.

Last month, the agency extended the waiver to tax year 2023 as well. But from next year, beneficiaries who do not withdraw RMDs will be subject to penalties.

Roth IRA, Non-Spouse Heirs

Beneficiaries who have inherited Roth IRAs rather than traditional IRAs do not have to pay taxes on withdrawals or make the RMD withdrawal as the original owner has also not taken them.

As such, inheriting a Roth IRA allows beneficiaries to keep funds in the account for 10 years without having to withdraw any amount, enabling the account to grow tax-free during this period.

The new SECURE rules on inherited IRAs only apply to non-spouse heirs. People who have inherited IRAs from spouses can treat the accounts as their own. Non-spouse heirs who have inherited the IRA prior to Jan. 1, 2020 can continue benefiting from the old rules.

The RMD amount a non-spouse beneficiary is expected to withdraw from an inherited IRA is calculated based on their life expectancy. The amount in the IRA account is divided based on the life expectancy factor of the beneficiary to arrive at the required minimum distribution.

Some non-spouse heirs are exempt from the SECURE rules on inherited IRA, such as minors, chronically ill or disabled people, and individuals who are within 10 years of the original account holder’s age.

Estate Taxes

Beneficiaries of inherited IRAs may also have to take into account estate taxes. In 2023, estates worth over $12.92 million will be subject to estate taxes, which is up from $12.06 million last year.

For estates that are subject to such taxes, beneficiaries of inherited IRAs can get an income tax deduction for the estate taxes that have been paid on the account. This is applicable to those who inherit traditional IRAs as any amount withdrawn from such accounts is subject to income tax.

“When you take a distribution from an IRA, it’s taxable income,” said Natalie Choate, lawyer and author of the retirement plan guide “Life and Death Planning for Retirement Benefits,” according to Bankrate.

“But because that person’s estate had to pay a federal estate tax, you get an income-tax deduction for the estate taxes that were paid on the IRA,” she said.

“You might have $1 million of income with a $350,000 deduction to offset against that. It’s not necessary that you were the person who paid the taxes; just that someone did.”