What happens when you inherit an IRA/401k? When do you take out money & pay taxes?

WRITTEN BY: Gideon Drucker, CFP® AIF® ECA

Today I am hoping to provide some context around what happens after you inherit a retirement account from a family member (or friend).

I'm providing this high level overview because it's an area that, unfortunately, will affect most of us at some point and that can throw people for a loop when they're not prepared!

Now, broadly speaking, when it comes to beneficiary account planning, there are two types of conversations we can have here depending on whether you are:

The account owner (and we are thinking ahead to what will happen when YOUR beneficiaries ultimately receive the funds.)

The beneficiary (and you just inherited an account that we need to decide how to distribute.)

For now, we're just going to discuss the planning opportunities if YOU inherited a retirement account because...

It's obviously the more time sensitive conversation (by definition, you're always inheriting an account at a chaotic & traumatic time and you're left wondering what you're supposed to do while balancing hundreds of other things).
This is likely what's most relevant to you... as the majority of our audience is at the age when they start thinking about the affairs (financial and otherwise) of their older loved ones.

So, to start, let's assume that you inherit a retirement account from a parent/aunt/uncle/family friend who recently passed...

Prior to The Secure Act 2.0 that was passed in 2019, the rules were pretty pretty simple and ultimately pretty fantastic for the beneficiary: If you inherited a Traditional IRA, you would have had to take out small RMD's (required minimum distributions) each year, but you could leave the bulk of the inherited account invested in a tax-deferred account & "stretch" the account (ie: not have to withdraw the funds) based on your own LONG life expectancy!

So, as an example, if you're 40 years old, you'd be able to leave an Inherited IRA alone to grow tax-deferred (and Tax-Free if it's a Roth account) for another FORTY YEARS before being forced to liquidate the account...that's four decades of tax deferral! Cool!

Ok, so that's the situation for accounts that you inherited PRIOR TO 2020.

Now, we have to deal with the The 10 Year Rule which stipulates that as the beneficiary you CANNOT stretch the account based on your expected lifespan...you have to take out all of the funds within 10 years of inheriting the account!

So that huge tax deferral just got slashed by decades....the IRS is basically saying, "we need the tax revenue & we want our cut sooner rather than later...so you need to liquidate this account (and pay the due taxes of course) within 10 years!"

Ok so that's the crux of it. An account that you used to be able to stretch out for decades (if desired) now has to be completely liquidated in 10 short years.

But there's a SUPER important distinction here.

If the person that you inherited the account from already was already taking THEIR required minimum distributions when they passed away, you have to take out required minimum distributions each year AND you have to liquidate the account by the end of the tenth year.

So it's not The 10 Year Rule or RMD's...it's the 10-year rule AND RMD's!! (Because remember RMD's are a minimum that you have to take out of the account and the 10-year rule says the ENTIRE account has to be liquidated in 10 years).

Ok, so what if you inherit an account from someone who was NOT already taking their Required Minimum Distributions?

In this case you don't have to take out money every year from the account...you just have to make sure that you've withdrawn it all by the end of the ten year period...you can take money out in whatever cadence you want to!

When you receive an account like this, you have 3 options...

I'm going to mention them briefly and then give examples of when it might be the best strategy:

Option #1: We can leave the account alone until the last second and distribute the entire account in the 10th year.

You would have to pay the taxes on the entire distribution in that tenth year...but you've effectively "bought" 10 years of tax deferral along the way (because you're letting the account grow without paying taxes during those 10 years.)

A few times/situations this makes sense:

If it's a Roth Account. If you inherit a Roth Account, we are ALWAYS going to defer taking distributions until the end of the tenth year!! You don't have to pay taxes on Roth distributions, so we absolutely want to let the money grow for as long as physically possible inside of the Roth "Wrapper". There's no tax reason to distribute the account out of a Roth IRA only to have it be re-invested in a LESS tax efficient account for the next 10 years. We want to wait until the 10th year and maximize the wealth growing in a tax-free account.
If it's a small balance with negligible tax impact. We might just decide to let it stay invested tax-deferred as it won't really have a tax impact either way and you're letting it stay in a tax-deferred wrapper.
If you're ALREADY in the highest tax bracket and you expect to be in the same high tax bracket for the next 10-20 years, we might just decide to buy the tax-deferral and pay the taxes in 10 years time...this is really who the tax-deferral is meant for. (Btw, this might sound like it contradicts our strong support for Roth Conversion but it's comparing apples to oranges: Once we do a Roth Conversion, your money STAYS in a tax-free account forever...but withdrawing an Inherited IRA up front ALSO results in taxes each year as that money will now be in a taxable account that has at least some tax drag.)

Option #2: We can take equal distributions over the next 11 years.

So if you have $1mm in the account, we would take out approximately $150,000 each year in distributions so as to liquidate the account by the end of the 11th* year. (accounting for growth in the account).

A few times/situations this makes sense:

If you are most likely going to be in the same tax bracket over the next 10-15 years. If you are going to be in the same tax bracket for the foreseeable future, we may decide that there's not much arbitrage in "picking" when to pay the taxes for these distributions, and we'd look to smooth out the distributions and spread out the taxes....which doesn't have much of a tax benefit (or cost)... but helps from a cash flow perspective as you're not creating cases where you need to come up with dramatically different amounts in tax payments in consecutive years.

Option #3: Proactively "pick" specific years to distribute the funds when you are in a lower tax bracket...

Similar to how we think through Roth Conversions, we may want to PICK the years we want to withdraw money out of your account to match the years that you're in the lowest tax bracket. If you normally make $300,000 but next year you're taking 8 months off for a sabbatical...well, we might decide to withdraw the $200,000 from the Inherited IRA because you would pay less in taxes when that money mostly fills the 12% or 24% tax bracket rather than the 32 or 37% tax bracket. It's the same dollars that you're receiving but a different tax rate depending on your OTHER income.

Now, some quick (and needed!) context to all of this....

This is the way we tend to frame the conversation from a TAX standpoint with our clients... but there might be cash flow reasons that we want to liquidate the account sooner/later (like you want to withdraw the money to pay off credit card debt or build back your emergency reserve after putting down a down payment or pay for college etc.).

As I always like to stay (stealing from one of my CPA partners) taxes are always a passenger on the financial decision making bus...they should not be the driver!

I hope this provided a helpful introduction to how we tend to think through these issues when they arise for our clients in real time.

As a friendly reminder we are always available to speak over a 15 minute Right Fit call if you feel you could use some help navigating your financial situation.

Together, we can determine if our Financial Life Plan® process is the right fit for you.

-Gideon