Inherited IRAs: New Rules and How to Calculate Your Taxes on Them

Inheriting an Individual Retirement Account (IRA) can be a significant financial opportunity, providing you with a source of income for years to come. However, the rules governing Inherited IRAs have undergone significant changes in recent years. These changes have both simplified and complicated matters, making it crucial for beneficiaries to understand the new regulations and their tax implications. 

At Steward Ingram & Cooper, PLLC, our Raleigh certified public accountants are committed to helping inherited IRA beneficiaries navigate this complex financial landscape, ensuring you make the most of your Inherited IRA. 

Understanding Inherited IRAs

Inherited Individual Retirement Accounts (IRAs) represent a unique subset of retirement savings vehicles that individuals may receive as beneficiaries after the original account holder’s passing. Understanding the intricacies of managing an inherited IRA is essential to making informed decisions about these accounts and maximizing their benefits. 

Types of Inherited IRAs

There are several types of Inherited IRAs, each with its own set of rules and considerations:

• Inherited Traditional IRA: When you inherit a Traditional IRA, you are typically required to take required minimum distributions (RMDs) based on your life expectancy or the “10-Year Rule,” depending on the circumstances. These distributions are subject to income tax.
• Inherited Roth IRA: Inheriting a Roth IRA offers unique advantages, as qualified distributions from Roth IRAs are typically tax-free. Beneficiaries of Roth IRAs may need to take RMDs but can enjoy tax-free growth and withdrawals.
• Inherited SEP IRA or SIMPLE IRA: These Inherited IRAs follow rules similar to Inherited Traditional IRAs, with beneficiaries required to take RMDs based on life expectancy or the “10-Year Rule.” Taxation depends on the original contributions’ tax status.
• Inherited Beneficiary IRA: In some cases, beneficiaries may have the option to set up a separate Inherited Beneficiary IRA to manage and distribute the inherited funds. This can provide flexibility in managing distributions and taxes.
• Inherited Non-Spousal IRA: Non-spouse beneficiaries, such as children or other family members, often have different rules and options compared to spousal beneficiaries. Understanding these distinctions is crucial when managing an Inherited IRA.

Benefits of Inherited IRAs

Inherited IRAs offer several benefits to beneficiaries:

• Tax-Advantaged Growth: An inherited IRA can continue to grow tax-deferred or tax-free, depending on the type of IRA. This allows the account to potentially increase in value over time.
• Income Stream: Beneficiaries can receive regular distributions from the Inherited IRA, providing a reliable source of income that can supplement their financial well-being.
• Flexibility: Depending on the IRA type and beneficiary’s age, there may be flexibility in how and when distributions are taken, allowing for customized income strategies.

New Rules for Inherited IRA

In recent years, inherited IRA rules have undergone significant revisions, primarily due to the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. These changes have profound implications for beneficiaries and their inherited IRAs, reshaping the landscape in which these accounts operate. 

In the realm of traditional IRAs, beneficiaries have historically faced tax obligations when inheriting these accounts. However, prior to the year 2020, there existed a valuable tax optimization strategy: spreading out withdrawals over one’s life expectancy. 

If you happened to inherit an IRA prior to 2020, you still retain the opportunity to employ this tax-efficient tactic, allowing you to elongate the process of withdrawals and, in turn, manage your tax liabilities effectively across your projected lifespan.

SECURE Act and its Impact on Inherited Traditional IRA

The SECURE Act, which became law in December 2019, introduced several critical changes to retirement planning and Inherited IRAs:

• Elimination of the “Stretch IRA”: One of the most substantial impacts of the SECURE Act was the elimination of the “Stretch IRA” concept for most non-spouse beneficiaries. Under previous rules, beneficiaries could take distributions based on their life expectancy, allowing for tax-deferred growth over an extended period. However, the SECURE Act replaced this with the “10-Year Rule.”
• The “10-Year Rule”: The SECURE Act now required most non-spouse beneficiaries to distribute the entire Inherited IRA balance within ten years of the original account holder’s death. While there are no annual RMDs, the account must be fully depleted by the end of the tenth year.
• Exceptions to the “10-Year Rule”: Certain beneficiaries, such as surviving spouses, minor children, disabled individuals, and those not more than ten years younger than the original account holder, are exempt from the “10-Year Rule” and can still use the life expectancy method for RMDs.

Under the SECURE Act, beneficiaries who inherited an IRA in the year 2020 would be required to clean out the account by the end of year 2030. 

Does the 10-Year Rule Apply to Inherited Roth IRAs? 

When it comes to inherited Roth IRAs, the “10-year rule” is applicable, but it comes with a noteworthy distinction: you are not obligated to pay taxes on the withdrawals, and there’s no requirement to take required minimum distributions (RMDs). This divergence stems from the fact that the original account holder was not subject to RMDs either. 

This unique feature grants you a high degree of flexibility regarding your withdrawal choices. However, if your financial circumstances allow for it, opting to wait until the tenth year to deplete the account can be a strategic move. By doing so, you can savor over a decade of tax-free growth on your inherited Roth IRA.

2022 IRS RMD Rules for Traditional Inherited IRAs 

In the ever-evolving landscape of tax on inheritance regulations and financial planning, the rules surrounding inherited traditional IRAs have seen their fair share of changes and clarifications. Initially, it was widely believed that non-spouse heirs inheriting a traditional IRA could stay in compliance with the law simply by depleting the account over a 10-year period. 

This approach held the promise of allowing beneficiaries to strategically minimize withdrawals during high-income years and, conversely, withdraw more when their income declined, such as during retirement.

However, a significant twist in the tale emerged with guidance issued by the IRS in February 2022. This guidance introduced a nuanced distinction that has important implications for some heirs. Here’s the crux of the matter: If your parent passed away before they were required to take minimum distributions, you retain the flexibility to withdraw funds at your discretion, in any amount, as long as the account is depleted within the 10-year window. 

However, if your parent passed away on or after the date when they were mandated to commence minimum distributions, the rules take a different turn. In this scenario, you must adhere to a schedule of required minimum distributions (RMDs) based on your life expectancy during the first nine years, culminating in the complete depletion of the account by year 10.

Looking Ahead: Latest Updates from IRS on Inherited IRA Accounts in 2024

To alleviate the confusion surrounding these rules, the IRS has extended a helping hand by waiving penalties for those who failed to take RMDs that should have been withdrawn from inherited IRAs in the tax years 2021 and 2022. Furthermore, in a welcome move, the relief has been prolonged to encompass the tax year 2023 as well. 

It’s worth noting, however, that beginning in 2024, you may find yourself obligated to commence distributions, so it’s never too early to start planning. Missing an RMD can come with a hefty penalty, amounting to 25% of the sum you should have withdrawn. Fortunately, if you rectify the missed RMD within two years, the penalty is reduced to 10%, offering some relief for those who may have inadvertently fallen short of these intricate IRS requirements.

How to Calculate Taxes on Inherited IRAs

Calculating taxes on an inherited IRA may seem like a complex task, but with some guidance, you can navigate it successfully. Let’s break down the process step by step to help you understand how to calculate taxes on your inherited IRA account. 

Step 1: Identify the Type of Inherited IRA

The first step in calculating taxes on your Inherited IRA is to determine the type of IRA you’ve inherited. Is it a Traditional IRA or a Roth IRA? The tax rules can vary significantly depending on the type.

Step 2: Determine Your Required Minimum Distributions (RMDs)

If you’ve inherited an IRA, you’ll need to calculate your Required Minimum Distributions (RMDs). The rules for RMDs differ depending on whether the original account holder has reached the age for RMDs or not.

• Original Account Holder Not Yet Taking RMDs: If the original account holder has not started taking RMDs, you can typically choose to take distributions at your own pace. However, you must empty the account by the end of the 10th year following the year of inheritance. No annual RMDs are required.
• Original Account Holder Already Taking RMDs: In this case, you’ll need to calculate RMDs based on your life expectancy. The IRS provides specific tables to determine the distribution amount. Failure to take the correct RMD can result in penalties.

Step 3: Calculate Tax Liability on Distributions

Once you know the distribution amount, you can calculate your tax liability. 

Here’s a simplified way to understand it:

• Traditional Inherited IRA: The distributions you take from a Traditional Inherited IRA are generally considered ordinary income and are subject to your regular income tax rate. The amount you withdraw each year will be added to your total taxable income.
• Roth Inherited IRA: Qualified distributions from a Roth Inherited IRA are usually tax-free. That means you won’t owe income tax on these withdrawals. However, if the Roth IRA hasn’t been open for at least five years, you may owe taxes on any earnings withdrawn.

Step 4: Strategies to Minimize Taxes

To minimize the tax impact of your inherited IRA, consider these strategies:

• Stretching the IRA: If you’re eligible, consider stretching the Inherited IRA distributions over a longer period to lower the annual tax burden.
• Roth Conversions: Depending on your financial situation, you might consider converting a Traditional Inherited IRA to a Roth IRA to enjoy tax-free withdrawals.
• Consult a Tax Professional: Tax laws can be complex, and everyone’s financial situation is unique. It’s often wise to consult an experienced tax professional to develop a personalized tax strategy.

Contact Our Inherited IRA Tax Planning Professionals in Raleigh 

Ready to navigate the complexities of inherited IRA tax planning with confidence and expertise? Look no further than the team of tax planning CPAs at Steward Ingram & Cooper, PLLC. 

Our dedicated team of Inherited IRA tax planning professionals in Raleigh is here to assist you every step of the way. Don’t let uncertainty about taxes on your inherited IRA hinder your financial goals. Contact us today to schedule a consultation and ensure you’re making the most informed decisions for your financial future. 

Get started now by calling us at  (919) 872-0866 or filling out the contact form below.