You just inherited an IRA — what to do now and how not to mess up - How to Invest

By Alessandra Malito

1 2

You may have heard of the five-year rule, which said that people must draw down the account within five years of the original account holder’s passing. That rule has mostly been washed away because of the Secure Act’s 10-year rule.

The five-year rule does still apply to beneficiaries of IRAs whose owners died prior to 2020 and before reaching age 70 ½ or to beneficiaries who are not people, such as a trust. (The Secure Act also changed when account holders must take required minimum distributions to 72; prior to 2020, the age when RMDs began was 70 ½ years old.)

Strategizing IRA withdrawals

Individuals pay income taxes on inherited IRAs only when money is withdrawn. But the elimination of the stretch IRA does make strategizing distributions all the more important for most Americans.

Beneficiaries should plan their withdrawals in line with their expected tax brackets. For example, someone who expects to be in a higher tax bracket in a few years may want to withdraw as much as they can from their inherited IRAs in the current year without pushing themselves into a higher tax rate. Someone who anticipates falling into a lower tax bracket in the next few years, however, would likely want to delay any distributions.

And remember: IRA distributions are taxed at ordinary income-tax rates, not the more favorable capital-gains rates.

Two more ways to mess up

Typically, Roth accounts (whether a 401(k) or an IRA) must be open for five years and the account owner must be 59 ½ years old to take any distributions tax-free. Beneficiaries who inherit a Roth before the five-year deadline should consult an accountant or financial planner to determine their next steps.

One last thing to watch out for: many retirement plans with the exception of the Roth IRA have required minimum distribution rules beginning at age 72. If the deceased turned 72 but didn’t take his or her RMD for that year, the beneficiary is responsible for taking that distribution. Failing to do so results in a penalty equal to 50% of the amount required to be distributed.

And if you do intend to keep the IRA, be sure to update it with your own beneficiaries — and warn them that they could have a new web of rules to untangle.

Become a better investor: Sign up for MarketWatch’s “how to Invest” newsletter.