Inheriting an IRA? Here's How Smart Tax Planning Can Save You Thousands
Receiving an inherited IRA can be a significant financial windfall but without careful planning, a large portion of that inheritance could end up in the hands of the IRS rather than your own. As one of the five pillars of holistic financial planning, tax management is especially critical when navigating the rules around inherited IRAs.
Understanding the Ten-Year Rule
Following the passage of the SECURE Act in 2019, most non-spouse beneficiaries who inherit an IRA are now required to fully withdraw the account balance within ten years of the original owner's death. Unlike the old "stretch IRA" strategy that allowed beneficiaries to spread distributions over their lifetime, the ten-year rule compresses that window considerably.
It's important to note that if the original owner was taking required minimum distributions (RMDs), the beneficiary must take RMDs throughout those ten years as well. However, only taking the RMD will not be enough to liquidate the account in ten years. Careful planning is required to avoid a major tax bill in that tenth year. Below are two common strategies to reduce taxes as much as possible.
Strategy #1: Target Your Lower-Income Years
For many beneficiaries, an upcoming retirement represents the single greatest tax planning opportunity when managing an inherited IRA. The years immediately following retirement, before Social Security begins and before RMDs kick in from your own retirement accounts, often create a window of unusually low taxable income. Taking larger distributions from your inherited IRA during this period can allow you to draw down the balance at a lower tax rate than you might face later in retirement when additional income sources come online.
It's also worth reconsidering the order in which you draw from your various accounts in retirement. Because an inherited IRA must be fully liquidated within ten years, it should generally be the first account you tap in retirement, ahead of your own IRAs, 401(k)s, or taxable accounts. This sequencing can sometimes dramatically shift your broader investment strategy. Knowing that your inherited IRA will be depleted first may mean you can afford to keep your own retirement accounts invested more aggressively for longer, since you won't need to touch them right away. It's a dynamic that many people overlook, but one that can have a meaningful impact on your long-term financial plan.
Strategy #2: Spread Distributions Evenly Over Time
If your income is relatively consistent throughout the ten-year period, an even distribution strategy may serve you better. By withdrawing roughly one-tenth of the balance each year, you avoid a large spike in taxable income in any single year. This approach keeps you from being pushed into a higher tax bracket and provides a degree of predictability for your overall financial plan.
The Bottom Line: It Depends on Your Situation
There is no universal right answer when it comes to managing an inherited IRA. The optimal strategy depends entirely on your personal financial picture — your current income, expected future earnings, other retirement accounts, tax filing status, and long-term goals. A lump-sum withdrawal might make sense for one beneficiary while a carefully timed, multi-year strategy is far more advantageous for another.
This is precisely where personalized tax planning makes all the difference. Working with a financial advisor who understands both the tax code and your unique circumstances can help ensure that your inheritance works for you, not against you.
Have questions about an inherited IRA or your overall tax planning strategy? Reach out to schedule a conversation.