As wealth continues to transfer from one generation to the next, inherited IRAs are becoming increasingly common.
While the term may sound straightforward, inherited IRAs come with unique rules and tax considerations that can significantly impact the person receiving them. Understanding what an inherited IRA is — and how it works — is essential before making any decisions.
At its most basic level, an inherited IRA is a retirement account that is passed to a beneficiary when the original owner dies. Once inherited, the account can no longer receive new contributions. Instead, the focus shifts entirely to how and when the money must be distributed. Those decisions are where complexity enters the picture.
How an inherited IRA is handled depends largely on the relationship between the original owner and the beneficiary. Spouses generally have the most flexibility. In many cases, surviving spouses can roll the inherited IRA into their own name and treat it as their own retirement account. Non-spouse beneficiaries, however, face very different rules.
Prior to 2020, many non-spouse beneficiaries could stretch distributions over their lifetime, taking smaller withdrawals each year. This approach, commonly known as the “stretch IRA,” allowed inherited funds to grow while spreading out the tax impact. That option changed with the passage of the SECURE Act, which took effect in January 2020.
Under the current rules, most non-spouse beneficiaries must fully withdraw the inherited IRA within ten years of the original owner’s death. Stretching distributions over a lifetime is no longer an option. While this doesn’t mean withdrawals must occur every year, the account balance must be reduced to zero by the end of that ten-year window.
The tax implications of this change can be significant. Inherited IRA withdrawals are typically taxed as ordinary income. Because beneficiaries often receive these accounts during their highest earning years, the added income can push them into higher tax brackets. From the IRS’s perspective, this accelerates tax collection — and it’s one of the primary reasons the stretch option was eliminated.
Inherited IRAs also interact with other tax rules in important ways. Required minimum distributions for original IRA owners have been pushed to later ages, which means larger balances may remain intact at death. When those accounts pass to heirs, the compressed ten-year distribution period can result in larger taxable withdrawals over a shorter time frame.
Key points to understand about inherited IRAs include the following:
- An inherited IRA is a retirement account passed to a beneficiary after the owner’s death.
- Spouse beneficiaries generally have more flexibility than non-spouse beneficiaries.
- Most non-spouse beneficiaries must withdraw the entire account within ten years.
- Distributions are typically taxed as ordinary income.
- Poor planning can result in higher taxes for the next generation.
Inherited IRAs can appear simple on the surface, but the rules surrounding them are anything but. The decisions made after inheriting an IRA — or while planning to pass one on — can have long-term tax consequences that extend beyond a single year. Understanding how these accounts work is the first step toward making informed choices that align with both current needs and future outcomes.
Financial Enhancement Group is an SEC Registered Investment Advisor.
