New Rules for Inherited IRAs

Key Takeaways   

• New rules require minimum distributions every single year and complete distribution within 10 years.  

• Strategic timing of distributions based on income levels can minimize tax impact of inherited IRAs. 

• Estate planning strategies include designating charities as IRA beneficiaries while leaving stepped-up basis assets to heirs. 

With such a hectic start to the new year, many folks have forgotten about the new rules for inherited IRAs that went into effect on January 1st. The new rules could complicate your distribution and tax planning. Here’s why. Starting in 2025, not only must you distribute the entire amount of an inherited IRA within ten years, but a certain minimum amount must now be distributed each and every year during that 10-year period. 

After the passing of the Secure Act, people who inherited IRAs on or after 2020 are required to distribute their account within 10 years. Gone are the days of the IRA “stretch” that allowed beneficiaries who didn’t need the money that badly to take very small distributions over decades to minimize their tax obligations. However, until 2025, there were no guidelines on how people had to distribute over the 10 years. Pre-2025 people had full discretion to take out as little or as much as they wanted each year and could wait to distribute the entire account in the 10th year if desired. That is until the IRS introduced updated guidance requiring that minimum distributions be taken out of inherited Traditional IRAs starting in 2025.

The calculation for the new inherited IRA Required Minimum Distribution (RMD) rule is similar to how 'Stretch IRA' RMDs were calculated under previous pre-2020 rules. The new rule only applies to Traditional IRAs inherited after December 31st, 2019, and if the decedent had begun taking RMDs before they passed. The rule does not impact inherited Roth IRAs which can still have their distributions delayed until the 10th year. While the new RMD rules require you to take out a minimum each year, you are still required to distribute the entire account balance by the end of the 10th year. If someone did not take an RMD between 2020-2024 before the new rule went into effect, they will not have to backdate distributions for those years.

If you’re curious, you can plug various assumptions into this Inherited IRA RMD Calculator from Schwab to determine how much you need to withdraw from the account each year to avoid penalties under the new rules. A sample screenshot is below: 

The new RMD rules require you to distribute AT LEAST the minimum amount each year but you still have the ability to distribute more if you choose. Coming up with a plan to unwind your Inherited IRA can be complex. Every dollar you distribute from an inherited traditional IRA is taxable income so waiting until the 10th year to distribute most of the funds could lead to an unpleasant 'tax bomb'. Some people choose to distribute an equal amount each year to spread out the tax impact.

Do I now have to take one-tenth of my inherited IRA each year? Not necessarily, and this is an area where we spend a lot of time helping clients. For instance, if you are having a high-income year, you can distribute much less than 10%, and then when you’re having a relatively low income year, we can elect to distribute more.  

Real world example 

We have a client who is about three years from retirement and just inherited a large IRA. Since he’s in his peak earning years, we're just going to distribute the minimum as per the calculator above. Once he's retired, however, we’ll start winding down the IRA more aggressively since he’ll be paying a much lower effective tax rate on the distribution in retirement.  

The estate planning aspects of inherited IRAs is another area where we’re helping many clients. If there’s a portion of the IRA you won’t need for your own wealth, we can carve out the unneeded funds and pass them on to your children as the primary beneficiary instead of the surviving spouse. We’ll start distributing those funds over the 10-year rule, and then when the second spouse dies, the children will get the other amount of inherited IRA and then have another 10 years to distribute that.  

This strategy allows the children to distribute the inherited IRA over far more than 10 years and minimize the tax consequences for each of those years. Many families find this preferable to having that same account value passed to the kids all at once as a second-to-die spouse and having to distribute the full amount in 10 years.  If you are leaving any money to charity in your will, another planning strategy is to make sure that the money comes from an IRA instead. That way, all the assets will get a step-up in basis will pass to heirs' tax free while the tax inefficient IRA assets satisfy the charitable bequest.  

Ideally, you want to leave the assets with a stepped-up basis to your heirs and leave the taxable IRAs to charity. As a charitable gift, you won’t pay taxes on the IRA and the charity will receive the IRA money tax-free assuming it’s a tax-exempt charitable organization. Thus, this maneuver reduces taxes for everyone involved. 

For example, if your will states that 5% of your estate is supposed to pass to charity, then you can name the charity as a listed beneficiary of your IRA. When you pass, the charity will treat your IRA as an inherited IRA. Because of its special tax status, the charity won’t have to pay taxes on those inherited funds. This preserves more tax-favorable assets for your heirs if you're leaving the remainder of your estate to your beneficiaries. 

Remember, the IRS wants to make sure the full amount of your inherited IRA gets distributed within 10 years so it can collect the full tax on it. It doesn’t want to wait decades for the funds to be hoarding or “stretched.” The IRS isn’t obligated to tell you the most tax-efficient way to take down your inherited IRA within that 10-year window. That’s where a skilled advisor comes in. Remember, there’s no one-size fits all solution for the new rules. Everyone’s situation is unique. 

Conclusion 

If you or someone close to you has concerns about the new rules or the most efficient way to wind down an inherited IRA, please don’t hesitate to reach out. I’m happy to help.  

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Devin Starr, CFP® Associate Wealth Advisor at Novi Wealth