Taxes on Inherited IRAs: What Beneficiaries Should Know

The IRS has very detailed rules in place for when you inherit an IRA. The way you can access the funds will depend on your relationship to the original account owner and, in some cases, whether they were taking required minimum distributions (RMDs). Further, the tax implications hinge on the type of retirement account you inherited and how the funds end up getting distributed to you. Understanding inherited IRA rules is essential for avoiding penalties and managing your tax liability effectively. While it can get complex, especially with large balances and multigeneration planning, we’re here to guide you through every step of the process. Read on to learn the ins and outs of taxes on an inherited IRA account and how to avoid the large, surprise tax bills they can bring.

What Is an Inherited IRA?

An inherited IRA is an IRA that’s left to a beneficiary after the account owner’s death. The original account owner designates the beneficiary in accordance with their plan’s requirements during their lifetime. Once they pass away, the account is often retitled as an inherited IRA for the benefit of the beneficiary. However, spouse beneficiaries can instead request that the inherited IRA be transferred into their own IRA.

Distribution Rules for Inherited IRAs

The distribution options available to the beneficiary of an inherited IRA depend on the beneficiary’s relationship to the original account owner. Here are the most recent inherited IRA rules established by the SECURE Act, which was signed into law in December 2019 and significantly reshaped how many types of beneficiaries must withdraw inherited retirement assets beginning in tax year 2020.

Spousal inherited IRA

A spousal inherited IRA refers to an inherited IRA that’s passed to the original account owner’s surviving spouse. Spouse beneficiaries have more options than their non-spouse beneficiary counterparts — as long as they’re the sole named beneficiary of an IRA.

If the original owner of a traditional IRA dies, the spousal beneficiary can opt to roll the account into their own IRA or keep it as an inherited account and take distributions based on their life expectancy. Further, if the original account holder’s death occurred before RMDs began, the spouse beneficiary has the option to keep the inherited account and follow the 10-year rule (empty the account within 10 years) or delay distributions until the original owner would’ve reached their applicable RMD age.

As for inherited Roth IRA accounts, spousal beneficiaries can take ownership of the account or keep it as an inherited Roth IRA. When kept as an inherited Roth IRA, these accounts have similar distribution options to inherited traditional IRAs when the owner dies before needing to take RMDs, as explained above.

Non-spousal inherited IRA

A non-spousal inherited IRA refers to an IRA that’s inherited by a beneficiary who isn’t the spouse of the original account owner. Designated non-spousal beneficiaries of inherited IRAs are split into two categories under the SECURE Act: eligible designated beneficiaries and designated beneficiaries.

Eligible designated beneficiaries include minor children of the deceased account holder, disabled or chronically ill individuals and individuals who aren’t more than 10 years younger than the IRA owner or plan participant. Regular designated beneficiaries include all other individuals.

This distinction is made because regular designated beneficiaries are only allowed to follow the 10-year rule when they inherit an IRA. Eligible designated beneficiaries, on the other hand, can opt to either follow the 10-year rule or take distributions according to the longer of their or the owner’s life expectancy.

If a non-spouse beneficiary isn’t an individual (such as an estate, charity or non-qualifying trust), the SECURE Act beneficiary rules aren’t applicable. Instead, the pre-2020 distribution rules for non-individual beneficiaries apply. That means:

• If the original account holder had a Roth IRA or wasn’t yet taking RMDs from a traditional IRA, the five-year rule applies.
• If RMDs from a traditional IRA were already mandatory, the beneficiary would be required to take RMDs based on the owner’s life expectancy,

Inherited IRA penalties

Now that you know the inherited IRA rules, you may be wondering what would happen if you were to accidentally break them. In typical IRS fashion, you would face penalties. If you’re required to take RMDs or liquidate your account within five or ten years but don’t, the IRS may charge an excise tax equal to 25% of the amount not distributed as required. However, your penalty tax rate may be reduced to 10% if you take the required distribution during an allotted correction window.

Tax Planning Strategies for Inherited IRAs

Inheriting an IRA may have significant tax implications. While qualified withdrawals from inherited Roth IRAs are tax-free, withdrawing Roth IRA earnings will trigger income tax if the account hasn’t satisfied the five-year holding requirement. Further, all distributions from inherited traditional IRAs are taxable and must be included in your gross income. If you inherit an IRA, it’s important to understand not only the distribution options available to you but also how they’ll impact your tax liability in the years to come. Strategic tax planning is essential for IRA beneficiaries navigating these decisions, particularly when managing IRA assets across multiple accounts.

Here’s a closer look at how each distribution option can impact your taxes:

• Required minimum distributions – RMDs require you to withdraw a set amount from the inherited IRA each year. In the case of traditional IRA or non-qualified Roth IRA withdrawals, you must include the amount you receive in your gross income when filing taxes each year and pay income tax on those distributions.
• Five- or 10-year rule – The five- and ten-year rules require you to withdraw all assets in an inherited IRA within a five- or ten-year timeframe, respectively. When the withdrawals are taxable, you must include them in your gross income in the year they’re taken and pay income tax at your ordinary rate.
• Roll the IRA into your IRA – If you roll funds from a spouse’s IRA into yours, the event isn’t taxable. The funds become part of your IRA and will be taxed on withdrawal according to your account’s rules.

The distribution options available to you will depend on the details of your inherited IRA situation and the specific IRA rules that apply. You might have only one option, or you may have up to four. If you have a decision to make, carefully consider the pros and cons of the different options. For example, RMDs generally spread disbursements out over decades, resulting in a smaller increase to your annual taxable income spread out over a longer period. On the other hand, the five- or 10-year rules force you to withdraw all IRA assets over a shorter period, often leading to higher tax brackets and larger annual tax liabilities but for a shorter number of years.

If you are not sure which distribution option is best or would like help planning for upcoming disbursements from an inherited IRA, consider scheduling time to discuss it with a financial professional. Coordinating inherited IRA tax planning with your broader financial plan is essential for HNW and UHNW individuals, as there are often many moving pieces to account for, making these decisions more complex than they can appear. A wealth manager can help you evaluate your options and make sure you understand the potential tax implications in the context of your broader financial picture, especially in light of One Big Beautiful Bill Act (OBBBA) tax changes.

FAQs About Taxes on Inherited IRAs

What is the tax rate on inherited IRA withdrawals?

When inherited IRA distributions are taxable, beneficiaries are required to include them in their gross income for the year. As a result, they’re taxed according to ordinary income tax rates at the taxpayer’s marginal rate. Because the U.S. tax system is progressive, higher withdrawals can push some of — or all — the distributions into a higher tax bracket.

What is the five-year rule for an inherited IRA?

The five-year rule for an inherited IRA states that the entire account balance must be withdrawn by the end of the fifth year following the year of the original account holder’s death. The SECURE Act largely replaced this rule with the 10-year rule, which now applies to inherited IRA situations resulting from deaths that occur after 2019. However, the five-year rule still applies if a beneficiary isn’t an individual and the original owner had a Roth IRA or died before RMDs on a traditional IRA began. It can also apply when the death of the original owner occurred before 2020.

How does an inherited IRA work?

When the owner of an IRA account passes away, the account is either retitled as an inherited IRA for the benefit of the beneficiary or transferred to a spouse beneficiary. The way in which a beneficiary can access the funds primarily depends on their relationship to the original owner. Potential options include rolling it into their own IRA (for spouses only) or keeping it as an inherited account. When it’s kept as an inherited account, beneficiaries will either take RMDs or withdraw the balance over five to ten years, according to inherited IRA rules. Taxable IRA disbursements are added to the beneficiary’s gross income in the year they’re received. If a beneficiary fails to take a required distribution from an inherited IRA, the IRS can impose an excise tax equal to 25% of the amount that should have been withdrawn.

Can I roll an inherited IRA into my own IRA?

You can only roll an inherited IRA into your own IRA of the same type if you’re the surviving spouse of the original account owner. This is usually done when the surviving spouse is younger than the original account owner. This option isn’t available to any other type of beneficiary. When done properly, the transfer is a non-taxable event. After the rollover, the surviving spouse may choose to move traditional IRA assets into a Roth IRA, but he or she will have to pay income taxes on the amount converted.

Do beneficiaries pay tax on IRA inheritance?

A beneficiary doesn’t owe tax simply for inheriting an IRA. However, beneficiaries are subject to IRS rules that determine how and when funds must be distributed from the account. If distributions are taxable, the amounts withdrawn must be included in the beneficiary’s gross income in the year they’re received. From there, they’re taxed at ordinary income tax rates. Distributions from inherited traditional IRAs are taxable, while qualified withdrawals from inherited Roth IRAs aren’t. That said, withdrawals of earnings from a Roth IRA account will be taxable if the account hasn’t yet met the five-year holding requirement.

We’re Here to Help

If you have questions or concerns about inherited IRA tax planning, the team at Creative Planning is standing by, ready to help. We specialize in working with HNW and UHNW clients on estate planning and taxes, and we’re experienced with the different ways inherited IRAs fit into broader financial strategies. Our advisors will help you evaluate your options under current IRA rules, manage your tax exposure on IRA assets and keep your long-term financial plan on track.

Schedule a meeting with a wealth manager to learn more.