Update: Rule Changes for Inherited IRAs

A few months ago I explained the confusing situation the IRS had put some of you in, regarding required minimum distributions for an inherited IRAs.

As promised, I am back with an update.

Let’s do a quick review. If you inherited an IRA after 2019 and you were not the spouse, you now typically must withdraw all the money from the IRA within 10 years following the year the account holder died. That’s a change from the old “stretch IRA” rules that allowed non-spouses to base their withdrawals on their own life expectancy.

What caused a bunch of confusion is that this year the IRS floated a proposal that said not only must you empty a non-spousal inherited IRA within 10 years, but you also need to be taking an annual required minimum distribution (RMD) for each year you still have money in the account.

And that set off worries that people who had inherited an IRA from someone who died in 2020 and didn’t take an RMD for the 2021 tax year could be hit with a big IRS penalty. The penalty for missing an RMD is 50% of what the IRS says you should have withdrawn from the account.

Okay, now some good news: If you inherited a non-spousal IRA in 2020 the IRS is not going to retroactively make you take an RMD for the 2021 tax year. Nor will you be hit with the 50% penalty for not taking the RMD. The same applies to inherited IRAs for the 2022 tax year: No RMD will be required, and no penalty will be levied.

Phew.

What’s still not clear is when annual RMDs for inherited IRAs will be expected. All the IRS says is that it might be 2023 at the earliest. Stay tuned.

While that’s a relief, I do want those of you with an inherited IRA that is subject to the 10-year withdrawal rule to be strategic in how you withdraw the money.

If the inherited IRA is a Roth IRA, you will still be held to the 10-year rule, but you will not owe tax on the withdrawals.

It’s a lot trickier if you inherit a traditional IRA. Every dollar you withdraw from a traditional IRA is taxed as ordinary income. If you have a large sum in a traditional IRA, and you wait until year 9 and/or 10 to make withdrawals, that could cause your taxable income to be so high that it bumps you into a higher tax bracket.

Taking smaller withdrawals over more years might be the better move if it means you won’t push yourself into a higher tax bracket. Or if there’s a year where your income is lower, that can be a good time to make a sizable withdrawal from the inherited traditional IRA.