Inheriting an IRA or 401(k): It is Not Always as Simple as It Seems
Inheriting money is often seen as a financial windfall, but depending on the type of asset you inherit, the situation can quickly get complicated. One prime example is when you inherit a retirement account—such as an IRA, 401(k), or another tax-qualified account.
When it comes to qualified accounts, taxes are due on the funds that the original account holder did not pay. The responsibility for these taxes then falls to you, the beneficiary. Historically, this was not a major planning or tax topic because you could simply ‘stretch’ the withdrawals over your expected lifetime. That is no more.
Starting in 2025, certain heirs are required to take an annual withdrawal and the entire account must be withdrawn with 10 years.
As of 2025, the landscape of inherited retirement accounts has changed, particularly with non-spousal inheritances, due to the significant overhaul introduced by the SECURE Act in 2019. The latest CRS report states that there as an estimated $37.8 trillion in retirement plans and IRAs. As baby boomers continue to age, they are passing on these assets to heirs, like you, who now face new tax rules and distribution requirements.
What Changed with the 2025 Ruling?
Previously, under the SECURE Act of 2019, non-spousal beneficiaries were required to withdraw the entire balance of an inherited IRA or 401(k) within 10 years, eliminating the once-popular "Stretch IRA" strategy that allowed beneficiaries to stretch distributions over their lifetimes. While the 10-year rule remained in place, the 2025 update provided a bit more clarity: A distribution must be made each of the 10 years or a penalty could be applied.
What to Plan For: The Tax Impact
How the tax implications affect your inheritance depends on a few key factors: the size of the account, your personal tax bracket, and when you choose to begin distributions and how sizeable they are.
If the inherited account balance is small or you are in a low tax bracket, the tax impact may not be substantial. However, for larger accounts or if you are a high-income earner, taxes could significantly reduce the amount you actually keep.
Distributions from traditional (non-Roth) inherited IRAs or 401(k)s will be taxed as ordinary income at your current tax rate, which could push you into a higher tax bracket. This is why effective planning is crucial. The RMD (required distribution) amount each year can vary based on several factors, including the beneficiary's age, relationship to the deceased, and the value of the inherited account.
Distribution Strategies and Considerations
So, what’s the best way to approach distributions from an inherited retirement account? Here are a few strategies to consider:
- Plan Around Your Expected Income or Retirement: If you expect your taxable income to decrease after retiring or soon for any reason, waiting until you are having a lower income to begin taking larger distributions could be a smart strategy. This way, you may withdraw funds when you are in a lower tax bracket, which could reduce the overall tax burden.
- Create a Distribution Plan for Your Expected Financial Events: If you are working and do not expect a downward move in income over the 10-year period, structure the distributions to fit your situation. Planning to buy a new home in 5 years? You could the inheritance for that. Create an investment strategy inside the account to fit that goal and distributions accordingly. There may be opportunities to strategically time distributions for purchases or investments: Education funding, travel, buying a cottage, etc.
- Avoid Taking a Lump Sum: One of the least tax-efficient strategies would be to likely be to withdraw the entire balance all at once, either immediately or in the 10th year. This could lead to a large tax bill as it would likely push you into a higher tax bracket. A more gradual approach to distributions could help mitigate this risk.
The Bottom Line
If you’ve inherited an IRA, 401(k), or other qualified assets, it's crucial to understand the specific distribution rules to navigate the best strategy for your unique situation. With the right approach, your inheritance can be optimized to your situation.