How to Avoid Penalties Under the New Inherited IRA 10-Year Rule

When your spouse or parent dies, you may inherit their retirement savings. What's the best thing to do with an inherited IRA? The inherited IRA 10-year rule governs how funds in a retirement account passed on to a beneficiary are handled.

A person can name their spouse, child, or close friend as heir to their IRA or 401(k) retirement savings when they die. Depending on your relationship with the person who left behind money in their retirement account, you may be subject to the inherited IRA 10-year rule.

The inherited IRA 10-year rule regulates the handling of a retirement account passed on to someone other than the spouse of the deceased. It means you would be subject to the rule if you inherited a retirement savings account from one of your parents. The rule requires that you deplete an inherited retirement account within 10 years of the death of the account’s original owner. The inherited IRA 10-year rule applies to accounts taken over by heirs beginning January 2020.

There are a few exceptions to the inherited IRA 10-year rule. First, you aren’t subject to the rule if you’re the spouse of the deceased account owner. Minor children of the deceased IRA owner are also exempt from the rule. The rule is waived where the heir is chronically ill or disabled. Another exception to the inherited IRA 10-year rule is where the heir is more than 10 years younger than the account owner.

An exception to the rule means that you can keep money in the inherited retirement account for longer than 10 years without facing penalties. Remember that if the exception was made on the basis of you being a minor, you would be subject to the rule once you attain the majority age.

If you’re the spouse, you can continue to take distribution from an inherited IRA. You can also wait until you retire to begin taking distribution from the account. The other option is to transfer the funds in the inherited IRA to your own retirement account. A spouse generally has plenty of flexibility when it comes to handling inherited retirement savings.

If you’re a child of the deceased IRA owner or other non-spousal heir, you may make a one-time lump-sum withdrawal or take out the money over time. What you need to remember is that the account should be empty by the 10th anniversary of the owner’s death.

For a traditional inherited IRA, taxes apply on withdrawals. The money is taxed as ordinary income. Therefore, you may end up in a higher tax bracket when you’re trying to deplete an inherited IRA. The good news is that when you’re taking from an inherited traditional IRA, you won’t be subject to the 10 percent early withdrawal penalty.

You can avoid taxes on an inherited retirement account if it’s the Roth type, such as Roth IRA or Roth 401(k). You can also avoid taxes if you decline to inherit the account. It’s advisable that you talk to a professional financial adviser about inheriting an IRA.