Strategies to Avoid Taxes on Inherited IRAs

Quick answer

• Understand the type of IRA you inherited (Traditional or Roth) as this dictates tax treatment.
• Most inherited Traditional IRAs require you to take distributions, which are generally taxable.
• Inheriting a Roth IRA usually means tax-free distributions, provided the original owner met Roth’s requirements.
• You have options for how and when to take distributions, which can impact your tax bill.
• Consult with a tax professional to understand your specific situation and optimize your strategy.
• Planning ahead can help minimize the tax burden on inherited IRA assets.

What to check first (before you invest)

Account Type

The first and most crucial step is to determine if the inherited IRA is a Traditional IRA or a Roth IRA. This is usually stated on the account statements or can be confirmed with the financial institution holding the account. A Traditional IRA’s contributions may have been tax-deductible, meaning withdrawals in retirement are taxed. A Roth IRA’s contributions were made with after-tax money, so qualified withdrawals are tax-free. This distinction is fundamental to how you will be taxed on the distributions.

Beneficiary Designation

Confirm your status as the beneficiary. The account custodian will have this information. If you are a spouse inheriting the IRA, you often have more options, including rolling it over into your own IRA. If you are a non-spouse beneficiary, your options are more limited, and specific rules apply, often referred to as the SECURE Act rules.

Required Minimum Distributions (RMDs)

Understand the rules for Required Minimum Distributions (RMDs) for inherited IRAs. For non-spouse beneficiaries, the SECURE Act generally mandates that the entire account balance must be distributed within 10 years of the original owner’s death. For spouse beneficiaries, the rules are more flexible, and you may be able to delay distributions longer. Failure to take RMDs can result in significant penalties.

Fees and Tax Impact

Be aware of any fees associated with managing the inherited IRA, such as administrative or investment management fees. These fees can reduce the overall value of the inheritance. More importantly, understand the potential tax impact of any distributions you take. For Traditional IRAs, this means estimating your income tax bracket in the year you take distributions. For Roth IRAs, confirm that the original owner met the five-year rule for qualified distributions.

Time Horizon

Consider your personal financial situation and how quickly you might need access to these funds. While there are rules about how quickly you must take distributions, you may have some flexibility in when within the 10-year period you take them. If you have a longer time horizon, you might be able to let the money continue to grow tax-deferred for a period, although this is constrained by the 10-year rule for most non-spouse beneficiaries.

Step-by-step (simple workflow)

1. Obtain the Death Certificate:

• What to do: Get certified copies of the deceased’s death certificate. You’ll need this to notify the IRA custodian.
• What “good” looks like: Having several certified copies ready to submit to the financial institution.
• Common mistake: Relying on a single copy or an unofficial document.
• How to avoid it: Order multiple certified copies when you first learn of the death.

2. Notify the IRA Custodian:

• What to do: Contact the financial institution where the IRA is held. Inform them of the account holder’s passing and that you are the beneficiary.
• What “good” looks like: The custodian acknowledges receipt of the death certificate and provides you with the necessary forms to claim the inheritance.
• Common mistake: Delaying notification, which can hold up the process and potentially impact distribution timelines.
• How to avoid it: Contact the custodian as soon as possible after obtaining the death certificate.

3. Confirm IRA Type and Beneficiary Status:

• What to do: Verify if it’s a Traditional or Roth IRA and confirm your role (spouse or non-spouse beneficiary).
• What “good” looks like: Clear confirmation from the custodian or account statements detailing the IRA type and your beneficiary status.
• Common mistake: Assuming the IRA type or misinterpreting beneficiary rules.
• How to avoid it: Ask direct questions of the custodian and review any documentation they provide.

4. Understand Distribution Rules (SECURE Act):

• What to do: Familiarize yourself with the 10-year rule for non-spouse beneficiaries, which generally requires full distribution within 10 years of the original owner’s death. Note any exceptions for eligible designated beneficiaries.
• What “good” looks like: Knowing the exact deadline for full distribution and any interim distribution requirements.
• Common mistake: Not being aware of the 10-year rule, leading to missed deadlines and penalties.
• How to avoid it: Read official IRS guidance or consult a tax advisor about the SECURE Act’s impact on your inherited IRA.

5. Decide on Your Distribution Strategy:

• What to do: Determine how you will take distributions over the 10-year period (for non-spouse beneficiaries). This could be lump sums, annual withdrawals, or a more strategic approach.
• What “good” looks like: A plan that aligns with your financial needs and tax situation, spreading out withdrawals to manage tax liability.
• Common mistake: Taking the entire amount at once without considering the tax consequences, or delaying too long and facing penalties.
• How to avoid it: Model potential tax impacts of different withdrawal scenarios and consult a tax professional.

6. Open an Inherited IRA Account (if needed):

• What to do: The custodian will likely help you set up a new account in your name as the beneficiary. This is often titled “IRA for the benefit of \[Your Name] as beneficiary of \[Deceased’s Name].”
• What “good” looks like: A properly titled account that reflects your ownership and the inherited status of the funds.
• Common mistake: Trying to merge the inherited IRA with your existing retirement accounts without proper titling.
• How to avoid it: Follow the custodian’s instructions precisely for setting up the inherited IRA.

7. Take Required Minimum Distributions (RMDs) (if applicable):

• What to do: If the deceased owner was already taking RMDs, you may need to take one for the year of their death. For non-spouse beneficiaries, you generally must start taking distributions in the year following the owner’s death, even if it’s not the full amount by the end of the 10-year period.
• What “good” looks like: Taking the correct RMD amount by the deadline each year.
• Common mistake: Forgetting to take an RMD or taking the wrong amount.
• How to avoid it: Set calendar reminders and use the custodian’s RMD calculation tools or consult a tax advisor.

8. Manage Investments within the Inherited IRA:

• What to do: Decide how to invest the funds within the inherited IRA. You can typically maintain the existing investments or reallocate them.
• What “good” looks like: Investments that align with your risk tolerance and time horizon, while still adhering to distribution rules.
• Common mistake: Making drastic investment changes without understanding the tax implications or liquidity needs.
• How to avoid it: Review the current investments and consider consulting a financial advisor about appropriate options.

9. Track Distributions for Tax Purposes:

• What to do: Keep detailed records of all distributions taken from the inherited IRA.
• What “good” looks like: Organized records including dates, amounts, and the type of distribution.
• Common mistake: Losing track of distributions, which can lead to inaccurate tax filings.
• How to avoid it: Use a spreadsheet or dedicated financial software to log all transactions.

10. File Taxes Annually:

• What to do: Report all taxable distributions from the inherited IRA on your annual tax return.
• What “good” looks like: Accurate and timely filing of your tax return, reflecting all income from the IRA.
• Common mistake: Not reporting IRA distributions, leading to IRS penalties and interest.
• How to avoid it: Work with a tax professional or use tax software that guides you through reporting these types of income.

Risk and Diversification (plain language)

When you inherit an IRA, the money is already invested. Understanding how it’s invested and the risks involved is crucial, especially since you’ll be taking distributions.

• Market Risk: This is the risk that the value of your investments could go down because of broad market downturns (like a stock market crash). For example, if the stock market drops 20%, your IRA investments might also drop.
• Interest Rate Risk: If your IRA is invested in bonds, rising interest rates can cause the value of existing bonds to fall. If interest rates go up, newly issued bonds will pay more, making older, lower-paying bonds less attractive.
• Inflation Risk: The risk that your money won’t grow as fast as the cost of living. If your investments grow by 3% but inflation is 4%, your purchasing power is actually decreasing.
• Concentration Risk: This is the risk of having too much of your money in one single investment or type of investment. For example, if your inherited IRA is entirely in one company’s stock and that company has problems, your entire inheritance could be severely impacted.
• Liquidity Risk: The risk that you might not be able to sell an investment quickly enough at a fair price when you need the money. Some investments, like real estate or certain alternative investments, can be illiquid.
• Diversification: This means spreading your money across different types of investments (stocks, bonds, real estate, etc.) and within those types (different companies, industries, geographies). The goal is that if one investment performs poorly, others might do well, smoothing out your overall returns. For example, an IRA invested in a mix of U.S. stocks, international stocks, and bonds is more diversified than one solely in U.S. tech stocks.
• Asset Allocation: This is the strategy of deciding how much of your money to put into different asset categories (like stocks vs. bonds) based on your goals and risk tolerance. For an inherited IRA, you might adjust this allocation based on when you need the money.
• Rebalancing: Periodically adjusting your investment mix back to your target asset allocation. If stocks have performed very well, they might now make up a larger portion of your portfolio than intended. Rebalancing involves selling some stocks and buying more bonds (or other underperforming assets) to get back to your desired mix.

What to do during market drops:

During market downturns, it’s natural to feel concerned. The most important thing is to avoid making impulsive decisions. Remember that market fluctuations are normal. If you have a diversified portfolio and a clear distribution plan, focus on sticking to it. For long-term investments, market drops can sometimes present opportunities to buy assets at lower prices. However, for inherited IRAs where you need to take distributions, ensure you have enough liquidity to cover your needs without being forced to sell investments at a loss. Consulting with a financial advisor can provide valuable perspective and help you navigate these periods calmly.

Common mistakes (and what happens if you ignore them)

Mistake	What it causes	Fix
Not confirming IRA type (Traditional vs. Roth)	Incorrect tax treatment of distributions; unexpected tax bills.	Ask the custodian for official documentation or account statements confirming the IRA type. If unsure, consult a tax professional.
Ignoring the 10-year rule (for non-spouses)	Significant penalties (25% of the undistributed amount if not taken by the deadline).	Mark the 10-year deadline on your calendar. Plan your distributions throughout the decade. Consult a tax advisor to understand exact RMD requirements.
Taking the entire inheritance as a lump sum	A large, immediate tax bill that could push you into a higher tax bracket.	Develop a distribution strategy to spread withdrawals over the 10-year period. This can help manage annual tax liability.
Not establishing an “Inherited IRA” account	Commingling inherited funds with personal accounts, leading to complex tax tracking.	Work with the custodian to set up a properly titled “Inherited IRA” account. This ensures clear separation for tax and legal purposes.
Failing to take annual RMDs (if applicable)	A steep penalty (25% of the amount that should have been withdrawn).	Understand if RMDs are required for your specific situation (especially if the deceased was already taking them). Use custodian tools or consult an advisor.
Misunderstanding “Eligible Designated Beneficiary” rules	Not qualifying for extended distribution timelines, leading to faster mandatory withdrawals.	Carefully review the IRS definition of an eligible designated beneficiary (e.g., minor children, disabled, chronically ill individuals). Consult a tax professional.
Investing too aggressively or too conservatively	Mismatch between investment risk and need for distributions, potentially losing money or growth.	Align your investment strategy with your time horizon and need for liquidity. Diversify across asset classes. Consider professional advice.
Not tracking distributions accurately	Errors on tax returns, potential for missed income reporting, and penalties.	Maintain detailed records of all withdrawals, including dates and amounts. Use spreadsheets or financial software for easy tracking.
Assuming all inherited IRAs are tax-free	Unexpected tax liability on distributions from Traditional IRAs.	Always confirm the IRA type and consult IRS guidelines or a tax professional regarding the taxability of distributions.
Procrastinating on seeking professional advice	Making costly mistakes due to lack of knowledge about complex rules.	Engage a qualified tax advisor or financial planner early in the process to ensure you understand all options and implications.

Decision rules (simple if/then)

• If you inherited a Traditional IRA and need the money within the next 10 years, then plan to take distributions strategically throughout that period because spreading them out can lower your annual tax burden.
• If you inherited a Roth IRA and the original owner met the 5-year rule, then you can generally take tax-free distributions because Roth IRAs grow and are withdrawn tax-free when qualified.
• If the deceased was already taking RMDs, then you likely need to take an RMD for the year of their death because the RMD rules continue into the year of death.
• If you are a spouse beneficiary and want to avoid immediate taxation, then consider rolling the inherited IRA into your own IRA because this allows you to treat it as your own retirement savings.
• If you are a non-spouse beneficiary and have no immediate need for the funds, then you can still take distributions strategically over the 10-year period, allowing the remaining balance to grow tax-deferred.
• If you are unsure about the tax implications of your distribution choices, then consult a tax professional because they can provide personalized guidance based on your income and tax bracket.
• If the inherited IRA has high fees, then consider transferring it to a custodian with lower fees because excessive fees erode your inheritance over time.
• If you are a beneficiary with a disability or chronic illness, then investigate if you qualify as an “eligible designated beneficiary” because this may offer more favorable distribution rules than the standard 10-year rule.
• If the market drops significantly, then avoid panic selling your inherited IRA investments because staying diversified and sticking to your distribution plan is often the best approach.
• If you receive an inheritance that is a substantial portion of your net worth, then seek advice on estate and income tax planning because large inheritances can have broader financial implications.

FAQ

Q1: Do I have to pay taxes on an inherited IRA?

A1: It depends on the type of IRA. Distributions from inherited Traditional IRAs are generally taxable as ordinary income. Distributions from inherited Roth IRAs are usually tax-free if the original owner met the Roth IRA’s 5-year rule.

Q2: What is the 10-year rule for inherited IRAs?

A2: For most non-spouse beneficiaries, the SECURE Act requires the entire balance of an inherited IRA to be distributed within 10 years of the original owner’s death. This applies regardless of the owner’s age at death.

Q3: Can I take money out of an inherited IRA all at once?

A3: Yes, you can typically take the entire balance as a lump sum. However, for Traditional IRAs, this can result in a very large taxable income in a single year, potentially pushing you into a higher tax bracket.

Q4: As a surviving spouse, what are my options for an inherited IRA?

A4: As a surviving spouse, you have more options. You can typically choose to take distributions under the non-spouse beneficiary rules, or you can elect to treat the inherited IRA as your own, which allows you to delay distributions and manage it according to your own retirement plan.

Q5: What happens if I don’t take distributions from an inherited IRA?

A5: If you are required to take distributions (such as RMDs or under the 10-year rule) and fail to do so, you can face a significant penalty, typically 25% of the amount that should have been withdrawn.

Q6: Can I roll over an inherited IRA to my own IRA?

A6: Only surviving spouses can generally roll over an inherited IRA into their own IRA. Non-spouse beneficiaries must typically establish a separate “inherited IRA” account and take distributions according to specific rules.

Q7: How are inherited Roth IRAs taxed?

A7: If the original owner met the 5-year rule for Roth IRAs, then qualified distributions from an inherited Roth IRA are tax-free. This means you generally won’t owe income tax on the money you withdraw.

Q8: Do I need to set up a new account for an inherited IRA?

A8: Yes, you will usually need to set up a new account specifically for the inherited IRA. This account will be titled to reflect that it is an inherited account, such as “IRA for the benefit of \[Your Name] as beneficiary of \[Deceased’s Name].”

Q9: Can I invest the money in an inherited IRA?

A9: Yes, you can typically continue to invest the funds within the inherited IRA. You can choose to keep the existing investments or make changes, but it’s important to consider your distribution timeline and risk tolerance.

What this page does NOT cover (and where to go next)

• Estate Taxes: This page focuses on income tax implications of inherited IRAs. It does not cover potential federal or state estate taxes that might apply to the deceased’s overall estate before assets are distributed.
• Specific Investment Advice: This guide provides general information on managing inherited IRAs. It does not offer specific recommendations for which investments to choose.
• State-Specific Tax Laws: While federal rules are discussed, state income tax laws can vary significantly. This guide does not delve into state-specific tax treatments of inherited IRA distributions.
• Complex Beneficiary Situations: This guide covers common scenarios. It does not address highly complex situations, such as multiple beneficiaries with differing needs, or IRAs with complex trust structures as beneficiaries.

Where to go next:

• Consult with a qualified tax advisor or CPA.
• Speak with a fee-only financial planner.
• Review IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).
• Contact the financial institution holding the inherited IRA for specific account information and forms.