Receiving an inheritance can be exciting for many, but when it involves individual retirement accounts (IRAs), the regulations can be quite intricate, and errors could lead to significant penalties.
Starting in 2020, certain inherited IRAs are subject to a “10-year rule,” meaning beneficiaries must withdraw all funds by the end of the tenth year after the original owner’s passing.
Moreover, non-spouse beneficiaries, such as adult children, are generally required to begin taking required minimum distributions (RMDs) by 2025 to avoid hefty IRS fines.
Inherited IRA plans play a crucial role in what some are calling a “massive wealth transfer.” A recent Cerulli Associates report predicts over 100 trillion dollars will change hands by 2048.
Here are the top three pitfalls to avoid when it comes to inherited IRAs, based on advice from financial professionals.
1. Ignoring IRS regulations
For heirs who aren’t spouses, the rules can be confusing. Brett Keppel, a certified financial planner based in Buffalo, New York, emphasizes knowing your options. The new RMD rules taking effect in 2025 will apply to most non-spouse beneficiaries, especially if the original owner had reached RMD age before they passed.
Failing to take the required RMD for an inherited IRA in 2025 could result in a penalty of 25% on the undeclared amount, although this can be reduced to 10% by following specific procedures. In some instances, the IRS may even waive the penalty altogether.
2. Underestimating tax liabilities
If you inherit a pre-tax IRA, expect to pay regular income tax on any withdrawals, which necessitates careful tax planning throughout the 10-year withdrawal timeframe.
Some beneficiaries might lean toward taking only the RMDs for the first nine years and then cashing out fully in the last year. However, as John Nowak, a certified financial planner from Mount Prospect, Illinois, points out, this could lead to substantial taxes in that final year. It may be better to plan withdrawals strategically across multiple years to minimize tax impacts.
3. Sticking with the same investments
A frequent mistake is keeping the inherited IRA investments unchanged. According to CFP Jamie Bosse from CGN Advisors in Manhattan, Kansas, your investments should align with your individual risk tolerance, financial goals, and timelines.
It’s essential to also consider your tax responsibilities, annual RMD requirements, and income necessities when selecting how to invest, as noted by Nowak. For instance, he suggests that IRAs with certificates of deposit maturing beyond the RMD timeframe can become challenging or pricey to manage.
