Published on January 2, 2024

When it comes to managing financial portfolios and planning for your future, there will be many unique challenges and opportunities. Leveraging Inherited Individual Retirement Accounts can help you preserve and transfer wealth across generations.

Individual Retirement Accounts (IRAs) have long been lauded as a vital tool for retirement savings, offering individuals a tax-advantaged vehicle to build financial security for their golden years. However, the landscape becomes considerably more intricate when IRAs are passed down to heirs, giving rise to a distinct set of regulations known as "Inherited IRA withdrawal rules." These rules govern how beneficiaries of inherited IRAs can access the funds while ensuring tax efficiency and compliance with the Internal Revenue Service (IRS) guidelines. 

Understanding Inherited IRAs

An Inherited IRA is an account that an individual inherits from a deceased account holder, typically a family member, spouse, or close relative. The purpose of an Inherited IRA is to allow beneficiaries to continue benefiting from the tax advantages of the account while distributing the inherited assets over time. If you or someone you love is the recipient of significant Inherited IRA assets, it is important to understand the implications. 

Types of Inherited IRAs

There are generally three types of Inherited IRAs, depending on the relationship between the original account holder and the beneficiary: spousal, non-spousal, and Roth.

Spousal Inherited IRA

When a surviving spouse inherits an IRA, they have the option to treat it as their own by rolling it into their existing IRA or creating a new one. It provides greater flexibility in terms of withdrawals and offers the advantage of delaying required minimum distributions (RMDs) until the age of 72 (or 73, if the person taking RMDs had not reached age 72 by December 31, 2022), thus potentially maximizing tax-deferred growth. 

Non-spousal Inherited IRA

For non-spousal beneficiaries — such as children, grandchildren, or other individuals — withdrawal rules vary based on whether the original account holder had already started taking RMDs. If the deceased had not started withdrawals, the beneficiary typically has two options: 

  • The Ten-Year Rule — In this case, the entire account must be emptied within ten years following the death of the IRA owner. Generally, a designated beneficiary is required to adhere to this rule, with the following exceptions: those who are the IRA owner’s spouse or minor child; are less than ten years younger than the IRA owner; or are disabled or chronically ill (as defined by the IRS).
  • The Life Expectancy Method — This involves calculating annual withdrawals using the beneficiary’s anticipated length of life and the value of the IRA in the year of inheritance. In this case, the beneficiary would have to begin taking distributions the year in which the deceased would have reached age 73 or December 31 of the year following the year of death. There are two types of life expectancy methods: Term-Certain, which is based on one’s life expectancy at the time of the first withdrawal; and Recalculation, which recalculates life expectancy each year.

If the deceased had already begun withdrawals, the beneficiary must continue taking RMDs calculated based on their own life expectancy. 

Beneficiary Designated IRAs, which arise when the original account holder designated specific beneficiaries on the account, fall under the same category and rules as non-spousal inherited IRAs.

Inherited Roth IRA

Roth IRAs have distinct rules due to their tax-free nature. For both spousal and non-spousal beneficiaries, Roth Inherited IRAs generally require RMDs based on the beneficiary's life expectancy. These distributions are tax-free as long as the original Roth IRA account was held for at least five years.

Strategies to Maximize Benefits

When it comes to Inherited IRA assets, strategic planning is essential to optimize tax efficiency and wealth transfer.

  1. Stretching RMDs: Leveraging the life expectancy method allows beneficiaries to stretch distributions over a longer period, potentially minimizing the tax impact and allowing more tax-deferred growth within the account.
  2. Tax Bracket Management: Consider current and expected future tax brackets. Timing distributions to coincide with lower-income years can reduce the overall tax burden.
  3. Wealth Transfer Planning: Non-spousal beneficiaries can name their own beneficiaries for the Inherited IRA. This enables a multigenerational wealth transfer strategy, as beneficiaries can continue to stretch distributions over their own life expectancies.
  4. Charitable Giving: For those with philanthropic inclinations, a qualified charitable distribution (QCD) can be made for the Inherited IRA directly to a charity, which fulfills charitable goals while potentially reducing taxable income.
  5. Conversion to Roth IRA: Depending on your financial situation, converting a Traditional Inherited IRA to a Roth Inherited IRA might make sense. Though it incurs immediate taxes, it can lead to tax-free growth and distributions in the future.

In Conclusion

Inherited IRA withdrawal rules can offer you a powerful tool for intergenerational wealth transfer and tax optimization. By strategically aligning these rules with your financial goals, you can secure your financial legacy while minimizing tax liability. Navigating the intricate landscape of Inherited IRA withdrawal rules requires a keen understanding of tax laws and financial planning. Working closely with your financial advisor, estate planner, and tax professional will ensure compliance with regulations and develop strategies tailored to your unique circumstances. 

If you have questions regarding inherited IRAs or financial planning topics generally, you can request an introduction to Osterweis Private Client.

Christopher Zand, J.D., CFP®

Vice President & Director of Private Client

Osterweis Capital Management does not provide tax, legal, or accounting advice. In considering this communication, you should discuss your individual circumstances with a professional in those areas before making any decisions.