Understanding inherited IRA rules for Ohio families

Dear Savvy Senior,

What are the rules regarding inherited IRAs? My brother and I recently inherited our father’s IRA when he passed away late last year and would like to know what we need to do to handle it properly.

Oldest Sibling

Dear Oldest,

I’m sorry to hear about the loss of your father, but you’re smart to be planning ahead. Inheriting an IRA from a parent comes with a unique set of rules. Understanding them can help you make the most of the money you inherit and avoid an unpleasant surprise at tax time. Here are some basics you should know.

Setting it up

Many people assume they can roll an inherited IRA into their own IRA, but that’s not allowed for most beneficiaries. If you inherit an IRA from a parent, sibling or anyone other than a spouse, you cannot treat the account as your own. Instead, your share must be transferred into a newly established inherited IRA, properly titled in the deceased owner’s name — for example, John Smith, deceased, for the benefit of Jane Smith.

If your father named multiple beneficiaries, the IRA can be split into separate inherited accounts. This allows each beneficiary to manage withdrawals independently, as if they were the sole beneficiary.

You can open an inherited IRA at most banks or brokerage firms, although the simplest option is often to set it up with the firm that already holds your father’s account.

The 10-year withdrawal rule

Under the SECURE Act, signed into law in December 2019, most nonspouse beneficiaries must withdraw all the money from an inherited IRA by the end of the 10th year following the original owner’s death. This rule applies if the owner died in 2020 or later.

If your father had already begun taking required minimum distributions, you generally must continue taking annual RMDs while also emptying the account within 10 years. If he had not yet started RMDs, annual withdrawals aren’t required, as long as the entire IRA is withdrawn by the end of the 10-year period.

You may take withdrawals faster if you choose, but distributions from a traditional IRA are taxable as ordinary income in the year taken. Roth IRA withdrawals, however, are usually tax-free, provided the account has been open at least five years.

If you fail to take a required RMD or don’t withdraw enough, the penalty is 25% of the amount you should have taken. That penalty can be reduced to 10% if the mistake is corrected within two years.

Exceptions to the rule

Several beneficiaries are exempt from the 10-year rule including a surviving spouse, a minor child, a disabled or chronically ill beneficiary, or someone who is within 10 years of age of the original IRA owner. These beneficiaries may be allowed to stretch withdrawals over a longer period.

Minimize your taxes

As tempting as it may be to cash out an inherited IRA in a lump sum or take large withdrawals over just a few years, proceed carefully. Doing so could trigger a hefty tax bill. Withdrawals from a traditional IRA are generally taxed as income at your regular tax rate.

For many heirs, spreading distributions over the 10-year period can help manage taxes and reduce the risk of being pushed into a higher tax bracket. Other strategies may make sense if your income fluctuates or you’re nearing retirement.

To help navigate these decisions, consider working with a financial adviser. If you don’t have one, you can find a fee-only, fiduciary financial planner through the National Association of Personal Financial Advisors at www.napfa.org.

Send your questions or comments to questions@savvysenior.org or to Savvy Senior, P.O. Box 5443, Norman, OK 73070.