So, you’re the beneficiary of an IRA or retirement plan? Here are some things you need to know.

Retirement accounts are often made up of money that has not yet been taxed. As the beneficiary, it’s great that this money has come to you, but withdrawing too much money in one year can cause your tax bill to be higher than if the taxation were spread out over many years.

For that reason, financial planning often is built on knowing the rules and delaying the tax bill for as long as possible.

Relationships Matter

As a beneficiary of an IRA or a retirement account, your relationship to the IRA owner matters. Formally, these fall into two categories.

Eligible Designated Beneficiary (EDB). If you were married to the account owner; are no more than ten years younger than the owner; or are a disabled child of the owner; you may be able to leave most of the money in the IRA, delaying taxes, and only be required to withdraw a small taxable amount each year. These are called Required Minimum Distributions (RMD) and are calculated based on life expectancy and the amount in the account. 

Designated Beneficiary. If you were named as a beneficiary but you don’t fit the above definition of an EDB, then you’re a Designated Beneficiary. In this case, you have ten years from the owner’s date of death to distribute all the funds paying taxes as money is distributed to you. You can distribute all the funds in year one, or distribute some each year, or some other pattern. But, by the end of the tenth calendar year following the year of the owner’s death, the account must be depleted. (Side note: if the owner died after their Required Beginning Date for Required Minimum Distributions – typically in one’s 70s – then you, the beneficiary, must be sure to take an RMD each year during the ten-year period, and still empty the account by the end of the tenth year.

Beware: Penalties 

There are penalties for not taking required RMDs. However, due to some confusion following Congress passing new rules, the federal government has waived any penalties in 2021-2024 for anyone who is a Designated Beneficiary and didn’t take RMDs in those years.

The Ten-Year Rule: Some Thoughts

If you are subject to the ten-year rule (with or without Required Minimum Distributions), you might wonder how best to empty the retirement account over those ten years. Remember, when money is withdrawn from the account, you will owe federal (and possibly state) income tax on those dollars. Some strategies include:

Take it all and get it over with. This is the simplest solution, but it could cost you more in taxes than taking smaller amounts each year. Taking a large withdrawal in a single year could increase your tax bite from, say, 22% to, let’s say, 34%, depending on the amount in question.

Waiting until year ten. This does indeed delay the pain of paying taxes now, but realize that as the account value grows over those ten years, the amount you’ll need to withdraw will grow as well, in turn increasing the amount you’ll have to pay in taxes. This strategy can easily result in your paying more in taxes than if you distributed it all in year one.

Taking it over time. Consider taking just enough each year to keep you from jumping up to a higher tax bracket. Consider also that in 2026, tax rates are scheduled to go up, which means that bunching some or all withdrawals into 2024 and 2025 could be a tax-saving measure.

Seek Guidance

The rules are confusing, not at all intuitive, and have changed in recent years. Consider working with a financial planner who understands the latest laws and can help you strategize to forge a path through this maze, so you can keep as much of this inherited money as possible.

Retirement accounts are often made up of money that has not yet been taxed. As the beneficiary, it’s great that this money has come to you, but withdrawing too much money in one year can cause your tax bill to be higher than if the taxation were spread out over many years.

For that reason, financial planning often is built on knowing the rules and delaying the tax bill for as long as possible.