If you’ve inherited an individual retirement account (IRA), staying up to date with the IRS’s latest regulations is crucial. Starting in 2025, new rules will impact how beneficiaries manage their inherited IRAs, particularly regarding required minimum distributions (RMDs). Failing to comply with these regulations could lead to steep penalties, making it essential to understand your obligations and plan accordingly.
Key Changes to Inherited IRA Rules
The IRS is reinforcing the 10-year rule, requiring most non-spousal beneficiaries to fully deplete inherited IRAs within a decade. Additionally, annual RMDs are typically required, and missing these withdrawals can result in penalties as high as 25% of the RMD amount. However, if corrected in a timely manner, this penalty may be reduced to 10%.
While these changes may appear daunting, proper tax planning strategies can help mitigate the impact. Below, we explore the critical elements of the new IRS rules and the best strategies to manage your inherited IRA effectively.
Background: The SECURE Act’s Impact on Inherited IRAs
Prior to the SECURE Act of 2019 and its successor, the SECURE 2.0 Act of 2022, IRA beneficiaries had more flexibility in managing withdrawals. The “stretch IRA” strategy allowed beneficiaries to spread distributions over their lifetime, reducing annual tax burdens.
However, these legislative changes introduced significant reforms:
SECURE Act of 2019
- Raised the RMD age from 70 ½ to 72.
- Replaced the five-year rule with a 10-year requirement for beneficiaries inheriting IRAs from individuals who passed away before starting RMDs.
SECURE 2.0 Act of 2022
- Increased the RMD age to 73 for individuals turning 72 after 2022 and further to 75 for those born in 1960 or later.
- Reduced penalties for missed RMDs from 50% to 25%, with a further reduction to 10% if corrected promptly.
Understanding the 10-Year Rule
Under the 10-year rule, most beneficiaries must withdraw all funds from an inherited IRA by the end of the 10th year following the original owner’s passing. This requirement applies whether or not the original account holder had begun taking RMDs before their death.
Failure to withdraw RMDs within the required timeframe results in a 25% penalty on the undistributed amount. However, if the missed distribution is corrected promptly, the penalty is reduced to 10%.
Between 2020 and 2024, the IRS provided transition relief, waiving penalties. However, beginning in 2025, the 25% excise tax will be fully enforced.
Special Considerations for Surviving Spouses
Surviving spouses have more flexibility when inheriting an IRA. Here are their options:
1. Assume the IRA as Your Own
- Spouses can treat the inherited IRA as their own and delay RMDs until their required start date.
- Example: If a spouse inherits an IRA from a deceased partner who was 55 in 2024, they can delay RMDs until April 1 of the year following when the deceased would have turned 75.
2. Elect to Be Treated as a Beneficiary
- This option allows withdrawals without incurring the 10% early withdrawal penalty for those under 59 ½.
- If the inherited account is a Roth IRA, surviving spouses can assume ownership and avoid RMDs entirely, allowing the funds to grow tax-free indefinitely.
Additionally, spouses may consider converting a traditional IRA into a Roth IRA to maximize long-term tax benefits.
Exceptions for Minor Children and Disabled Beneficiaries
The 10-year rule does not immediately apply to minor children. Instead, the 10-year withdrawal period begins when the child reaches the age of majority (typically 21). This allows additional tax-deferred growth before mandatory withdrawals begin.
Disabled or chronically ill beneficiaries may qualify for an exemption from the 10-year rule, allowing them to stretch distributions over their lifetime.
Tax Planning Strategies for Other Beneficiaries
If you do not qualify for any exceptions under the SECURE Act, strategic planning is essential to minimize tax liabilities.
1. Spread Withdrawals Evenly
- Instead of taking large lump-sum distributions, spread withdrawals over the 10-year period to avoid higher tax brackets.
- Example: If inheriting a $100,000 IRA, withdrawing evenly over 10 years may keep you in a lower tax bracket, potentially saving thousands in taxes.
2. Time Withdrawals Based on Tax Rates
- If tax rates are expected to rise, consider accelerating distributions.
- Conversely, if you anticipate lower tax rates in future years, delaying withdrawals may be beneficial.
Key Takeaways
- Act Now: The IRS’s 10-year rule for inherited IRAs is in full effect, with significant penalties for non-compliance starting in 2025.
- Surviving Spouses: Carefully weigh the benefits of assuming ownership versus being treated as a beneficiary.
- Minor Children: Understand when the 10-year clock starts to ensure full withdrawal by age 31.
- Other Beneficiaries: Use strategic withdrawal timing to optimize tax efficiency.
By understanding these IRS updates and implementing smart tax strategies, you can minimize your tax burden and ensure compliance with the new rules. Consulting a tax professional can provide personalized guidance tailored to your financial situation.
