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These inherited IRA mistakes could reduce your windfall, advisors say
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While many investors welcome a windfall, the rules for inherited individual retirement accounts are complicated — and mistakes can be costly.
Since 2020, certain inherited accounts are subject to the “10-year rule,” and heirs must empty the balance by the 10th year after the original account owner’s death.
Plus, some non-spouse beneficiaries, commonly adult children, must begin taking required minimum distributions, or RMDs, in 2025 over the 10-year period, or face a hefty IRS penalty.
Inherited IRA planning is important amid the “great wealth transfer,” with more than $100 trillion expected to change hands through 2048, according to a December report from Cerulli Associates.
Here are three of the biggest inherited IRA mistakes and how to avoid them, according to financial advisors.
1. Not knowing the IRS rules
For non-spouse heirs, “the [inherited IRA] rules can get complex fast, and it’s critical to know your options,” said certified financial planner Brett Koeppel, founder of Eudaimonia Wealth in Buffalo, New York.
The “10-year rule” and new RMD requirement for 2025 apply to most non-spouse beneficiaries, such as adult children, if the original IRA owner reached RMD age before their death.
If you fail to take inherited IRA RMDs for 2025, you could be subject to a 25% IRS penalty on the amount you should have withdrawn. However, you could reduce that fee to 10% by disbursing the correct amount within two years and filing Form 5329. In some cases, the IRS may waive the penalty entirely.
2. Not planning for ‘significant taxes’
If you inherit a pretax IRA, you can expect to pay regular income taxes on withdrawals, which may require tax planning during the 10-year drawdown, experts say.
Some heirs aim to take only their RMD for the first nine years and a lump sum in year 10. But this could mean “significant taxes in that final year of distribution,” said CFP John Nowak, founder of Alo Financial Planning in Mount Prospect, Illinois. He is also a certified public accountant.
Instead, you should run multi-year tax projections to decide the best withdrawal amounts for each year, experts say. For example, it might make sense to accelerate distributions during temporary lower-income years.
3. Keeping the same investments
Another common mistake is failing to change inherited IRA assets, according to CFP Jamie Bosse, a senior advisor at CGN Advisors in Manhattan, Kansas.
Ideally, the investments should match your risk tolerance, goals and timeline. “It’s your money now and should be allocated according to your needs,” she said.
However, when choosing investments, you need to weigh your tax liability, yearly RMD and income needs, said Nowak with Alo Financial Planning.
For example, holding certificates of deposit in your IRA with a maturity date beyond your RMD window could be “difficult or costly to distribute,” he said.
