Losing your last parent is never easy. In addition to dealing with grief, there is a good chance that you may be a beneficiary of their retirement account. It’s a time of mixed emotions, you feel blessed for what they left you, but experience a void that they are gone. Retirement accounts are often one of the largest assets that a person may own. It is important that you quickly gain an understanding of the tax requirements surrounding your role as a beneficiary and that you do not delay completing the paperwork required to take control of these assets. The silver lining is that with careful planning, you can honor your parents’ legacy and make the most of the gift you have received.
Who You Are as a Beneficiary
Spouses have a unique flexibility in that they may choose between keeping the account as an inherited IRA or rolling the inherited IRA funds into their own account. When you are a non-spouse beneficiary your options are to take a full taxable distribution of the entire account balance or to create a beneficiary IRA. Prior to ___, beneficiary IRAs could be distributed over the life expectancy of the beneficiary. Non-spouse beneficiaries now are almost always required to fully distribute the IRA balance within IRA’s are bounThese accounts are bound by the 10-year rule, which we will explore in more detail in the next section. The rules for this group depend on whether the decedent has begun RMDs or not; when decedents pass before RMD age, a 5-year rule applies, otherwise the payout is based on the decedents remaining life expectancy. The key to remember here is that naming an estate and certain trusts as a beneficiary is often less tax efficient.
How Distributions Work
Knowing which classification you fall into is only half of the equation. The next key step is understanding how your classification impacts your distribution rules. This is where the 10-year rule comes into play. According to the 10-year rule, IRA accounts must be emptied by December 31st of the 10th year after the decedent’s death. To put concrete dates on it, if someone were to pass away on September 15th of 2025, their designated beneficiary must have emptied the account by December 31st of 2035. Under current IRS guidance, if the decedent had already begun their RMDs, then the beneficiary must take annual RMDs in years 1-9 as well. The RMDs are calculated based on the beneficiary’s life expectancy from the IRS Single Life Table. In theory, assuming RMDs had not started yet, a beneficiary could elect to wait until the 10th year to take any distributions, but as we will explore later in the article, this can have unintended tax consequences. When an IRA distributes funds, it is taxable as ordinary income to the recipient, so for many beneficiaries, the ability to stretch distributions over their lifetime helped manage their tax liability effectively.
There are, of course, exceptions to the 10-year rule that apply when beneficiaries are of a different classification. Minor children, for example, are considered EDBs until the age of majority (usually age 18), and can use the stretch life expectancy method of RMDs based on their own life expectancy. In practice, this means that withdrawals are typically smaller than would otherwise be required under the 10-year rule. Once they’re adults, though, the distribution clock begins. Minor children don’t get to fully defer distributions until the age of majority, but they do get an extended runway. For the disabled and chronically ill beneficiaries who are less than 10 years younger than the decedent, they can maintain the stretch distribution status, taking RMDs according to their own life expectancy. Another nuance is the 5-year rule, which is triggered when there is no designated beneficiary, and the decedent dies before RMD age. This can occur when the beneficiary is the estate or certain types of trusts. In this case, the account must be emptied over five years instead of ten. Were the decedent to have already been in RMD-age, and the beneficiary was an NDB, then the RMDs would continue according to the decedent’s life expectancy. Roth IRAs generally follow the same beneficiary rules as Traditional IRAs, but with the caveat that beneficiaries can allow the funds to grow tax free and are usually not taxed upon distribution. Roth IRAs do not trigger annual RMDs in years 1-9 since owners never had lifetime RMDs.
Tax Consequences
Timing matters just as much as the distribution rules themselves. Fortunately, beneficiaries have strategies for managing the impact. With careful planning, it’s possible to smooth out taxes and avoid costly mistakes. Traditional IRA distributions, regardless of beneficiary status, are taxed at the ordinary income tax rate of the beneficiary. Contrary to many beneficiary’s understanding, there is no capital gains treatment of assets inside an IRA; the amount of basis in the account is irrelevant for tax purposes, and beneficiaries cannot benefit from preferential capital gains tax rates. Similarly, there is no step-up-in-basis on assets in an IRA, so beneficiaries need to be cognizant of the full-income tax treatment of their distributions.
Roth IRAs generally follow the same distribution rules, with the significant advantage that withdrawals are tax-free if the original owner held the Roth account for at least the last five years. If the initial owner passes away before the five year clock is complete, then the beneficiary faces two possibilities: distributions of contributions remain tax-free, while earnings are taxed as ordinary income until the 5-year period is complete. If possible, waiting until the 5 years have passed allows all withdrawals to be tax-free. There are generally no annual RMDs for inherited Roth IRAs because the decedent themselves never had RMDs on the account.
It’s key to remember that some states charge income-tax on beneficiary IRA distributions as well, so it’s important to plan for the full tax consequences. For accounts requiring an RMD, the penalties for missing a distribution can be steep: 25% of the shortfall, reduced to 10% if corrected promptly.
All of this underscores an important point: while the rules determine when distributions must occur, it’s the planning that determines how those distributions affect you. Beneficiaries have very little control over the tax status of the assets that they inherit, but they do have meaningful choices to make about the timing of withdrawals and how accounts are structured and titled. In the next section, we will explore some of the most effective ways beneficiaries can navigate these rules to manage their inheritance wisely.
Planning Opportunities
Tax Bracket management is one of the most straightforward methods to manage the tax treatment of beneficiary IRA distributions. As we recall, withdrawals are taxed at ordinary income rates, and stack on top of other earned income for the year. Often, beneficiaries are in their 50s or 60s, their key earning years, and are forced to take additional income when the timing is not the most ideal. Spreading withdrawals across a few years, or opting to wait for lower income years, can be strategic planning techniques to minimize the tax consequences of distributions. For individuals a few years from retirement, it may be advantageous to delay distributions to take advantage of low-to-no-income years. They can fill up lower income tax brackets and use the distributions to support spending needs in the first years of retirement.
Account titling and beneficiary designations, too, present planning opportunities to be considered. When there are multiple beneficiaries on an IRA, it is often beneficial for beneficiaries to “split” the inherited IRA into separate accounts. They can elect to do so by December 31st of the year following death. This is usually most prudent when beneficiaries have different income tax circumstances and want to customize their distributions to reflect that. Without separate accounts, distributions must be handled collectively, which can create tax inefficiencies if heirs are in different tax brackets.
When trusts are beneficiaries, it is important to understand if they are accumulation or conduit trusts. Accumulation trusts give trustees discretion on how and if they will distribute the trust income, but retained income is taxed at significantly compressed rates compared with individual tax rates. Conduit trusts must distribute all of the trust income, but this forces beneficiaries to recognize all distributions as taxable income.
For families who are charitably inclined, IRAs can either be left directly to a philanthropic organization, or IRA distributions can be paired with charitable giving to help offset income tax consequences through itemized deductions. From a tax perspective, leaving Traditional IRAs to charity is often more efficient, while Roth IRAs are generally more favorable to leave to children or other beneficiaries.
It is essential to ensure proper titling and treatment of inherited IRAs, regardless of tax strategy. If the inherited IRA is titled improperly, it can sometimes cause the IRS to treat it as if it were fully distributed, creating an immediate, unexpected tax bill. Non-spouse heirs must ensure that the IRA remains titled in the decedent’s name “for the benefit of” the beneficiary. This is often written as: Jane Doe, IRA (deceased 1/1/2025), FBO Joan Doe, Beneficiary.
Real-Life Scenarios
Imagine a scenario where two siblings inherit a Traditional IRA from their parents. One sibling earns $400,000 while the other earns $60,000, putting them in very different tax brackets. In this situation, there is a strong case for splitting the IRA into two separate inherited accounts, each titled in their own name. Rather than being forced to make withdrawals collectively, each sibling can manage distributions on their own terms — allowing the higher earner to time withdrawals during lower-income years, while the lower earner can begin taking distributions at a more favorable tax rate.
Conclusion
Inheriting a parent’s IRA can be fraught with emotion and complex responsibility. The rules governing distributions, taxation, and planning opportunities are nuanced, and the choices beneficiaries make often have significant and lasting tax consequences. This, combined with the grief of losing a loved one, makes it especially important to clearly understand how to classify and manage distributions. If you’ve inherited an IRA, or are planning how best to leave retirement assets to your family, professional guidance from Blue Chip Partners can help you navigate the rules with confidence and align decisions with your financial goals.
Disclaimer: Individual views and opinions expressed in the podcast, article, or other media included herein may not necessarily reflect the views and opinions of Blue Chip Partners, LLC. This material has been prepared for informational purposes only and is not intended to provide and should not be relied on for individualized financial, tax, legal or accounting advice. You should consult your own professional financial, tax, legal, accounting, or equivalent professional prior to making any investment decision. All investments involve a degree of risk, including the risk of loss. Past performance is not indicative of future results.
