Inheriting an IRA in 2020 or later brought about a set of new rules for non-spousal beneficiaries, reshaping the landscape of required distributions and the subsequent tax implications—particularly within traditional IRAs.
The pivotal shift that took effect in 2020 mandated a ten-year distribution timeline for non-spousal IRA beneficiaries. This rule held true regardless of age, requiring beneficiaries to deplete the inherited account within a decade. The objective behind this rule change was to allow the federal government to collect income tax on the funds from traditional IRAs. Even inherited Roth IRAs were not exempt from this regulation, though the tax liability was eliminated, relinquishing the beneficiary’s opportunity for continued tax-free growth.
Adding to this, the IRS introduced an unexpected twist—insisting that beneficiaries must adhere to annual Required Minimum Distributions (RMDs) unless the account was depleted swiftly. The penalty for not complying with an annual IRA RMD, which previously stood at 50%, was scaled down to either 10% or 25%. Naturally, this prompted concerns about potential penalties for missed RMDs in the years 2021 and 2022.
To the relief of many, the IRS intervened and proclaimed that there would be no penalty incurred for failing to take the RMD from an inherited IRA during those years.
Now, this relief has been extended to encompass the 2023 tax year as well, implying that no penalty will be imposed if the RMD is skipped in this time frame.
However, this doesn’t necessarily mean that you shouldn’t consider taking the RMD. Crafting a strategic RMD approach within the 10-year span remains crucial for optimal tax management. While it might be tempting to allow the funds to continue growing tax-deferred until the final year, there’s a vital caveat: a substantial withdrawal in the concluding year could potentially push you into a higher tax bracket due to the nature of ordinary income taxation applied to every dollar extracted from a traditional IRA.
One approach to navigate this taxation challenge is to withdraw smaller sums annually throughout the ten-year period or spread them over a few years. Additionally, if you find yourself in a year characterized by lower income, it might be prudent to contemplate withdrawing a more substantial amount during that specific year, as you could potentially find yourself in a lower income tax bracket.
These considerations underscore the importance of devising an RMD strategy that aligns with your tax objectives over the course of the inherited IRA’s ten-year timeline. By making informed decisions, you can optimize your tax outcomes while effectively managing your inheritance.