Podcast Episode 367: An IRS Update on Inherited IRAs

Inherited IRAs can be a financial lifeline, but they come with their own set of complexities, especially with the rule changes introduced in 2020. If you’ve recently inherited an IRA or are planning for the future, understanding these changes and how to manage your inheritance effectively is crucial. In our latest episode of Money Wisdom, we sat down with Heath Grossman, CFP® to break down the ins and outs of inherited IRAs and offer strategies to minimize your tax burden.

So, what exactly is an inherited IRA? As the name suggests, it’s an Individual Retirement Account that you inherit from someone else, typically a non-spouse. While it might sound straightforward, the rules governing these accounts have undergone significant changes in recent years, adding layers of complexity to an already intricate financial landscape.

Prior to 2020, beneficiaries of inherited IRAs could stretch out distributions—and the associated taxes—over their lifetime, a strategy known as the “stretch IRA.” However, the rules changed in 2020, requiring most beneficiaries to fully distribute the inherited IRA within ten years. This shift means that instead of spreading the tax burden over many years, beneficiaries now face a compressed timeline, potentially leading to higher annual tax liabilities.

One of the most confusing aspects of these new rules is the requirement for minimum distributions. Initially, it was thought that beneficiaries could distribute the funds at their discretion over the ten-year period. However, subsequent guidance from the IRS introduced the concept of required minimum distributions (RMDs) for certain beneficiaries, adding another layer of complexity. The IRS has even provided temporary relief by waiving RMDs for specific years, but this has only added to the confusion.

So, how should you manage an inherited IRA under these new rules? There are several strategies for different scenarios. For instance, if the inherited IRA is relatively small, it might make sense to withdraw the entire amount in the first year to simplify your financial situation and avoid ongoing administrative tasks. On the other hand, if you’re nearing retirement and expect your income to drop, deferring distributions until after you retire could be a smart move to minimize your tax burden.

Another common approach is to take equal distributions over the ten-year period, spreading the tax liability evenly and avoiding a large tax hit in any single year. This strategy can be particularly effective if the inherited IRA is substantial and you want to manage your income levels carefully.

The key takeaway from this conversation is that there’s no one-size-fits-all solution. The best approach depends on your unique financial situation, your current and future income levels, and your overall retirement strategy. Given the complexities involved, consulting with a financial advisor is essential to ensure you’re making the best decisions for your circumstances.

Here’s some of what we discuss in this episode:

• An explanation of an inherited IRA and how it’s different than a regular IRA.

• What changed with the rules around an inherited IRA in early 2020?

• What it means for Required Minimum Distributions.

• When would it be logical to withdraw the entire inherited IRA in year one?

• When would it make sense to wait as long as possible to take the money out?