For many people, growing older increases the chance of inheriting an IRA at the death of a loved one. Such a bequest can create unexpected tax (and stealth tax) problems. Savvy planning can help to ease the emotional and financial pain.
The possible cause of distress is the fact that beneficiaries of tax-deferred traditional IRAs (as well as beneficiaries of tax-deferred retirement accounts such as traditional 401[k]s) generally face required minimum distributions, which usually count as taxable income. Such RMDs will swell “combined” or “provisional” income, which might raise the tax owed on Social Security benefits. Potential taxation of Social Security income never goes away based upon one’s age, only upon one’s level of income. The thresholds for increased taxation have not been adjusted for inflation since they were established in 1984.
RMDs also can boost modified adjusted gross income (MAGI), as calculated for the purpose of determining whether enrollees face steep Income-Related Monthly Adjusted Amounts for Medicare Parts B and D premiums, in effect a stealth income tax. For example, in 2025 the standard premium for Medicare Part B (medical care) is set at $185 a month, or $2,220 a year. High-income enrollees will pay up to $629 a month--$7,548 a year—for the same insurance coverage.
Realizing the rules
An inherited IRA can have differing impacts on beneficiaries, depending on whether they are Non-Designated Beneficiaries (NDBs), Eligible Designated Beneficiaries (EDBs) or Non-Eligible Designated Beneficiaries (NEDBs). Depending on individual circumstances, they might be subject to a 5-year rule or a 10-year rule for account depletion; or, they might be eligible for a lifetime stretch of smaller RMDs. In all cases, beneficiaries must follow the relevant rule to avoid IRS penalties.
That said, it’s important to realize these are minimum obligations. Beneficiaries holding inherited IRAs may find it makes sense to withdraw more money from these accounts in some years, even if current tax payments increase.
Indeed, taking minimum distributions or even no distributions for 9 years might lead to a large withdrawal at account depletion in year 10. A sizable balloon distribution then could be highly taxed, depending on the amount involved and on then-current tax rates. The inherited account holder should anticipate the year-10 tax bill, which could lead to attempts to reduce or eliminate the balloon’s size with larger than minimum annual distributions. For those who can afford it, tax-wise, we suggest dividing the account value by 10 in year 1 and reducing the divisor by 1 each subsequent year; for others, we take a variable amount that might be greater than the RMD, with guidance from the client’s tax professional.
Sooner than later
For example, suppose Alice inherits an IRA in late 2024, shortly before becoming eligible for Social Security retirement benefits upon reaching age 62 in 2025. If she is considered disabled, Alice would be entitled to a lifetime stretch of RMDs for maximum tax deferral.
However, now that Alice has inherited an IRA before collecting Social Security, she might consider delaying her retirement benefits and spending down the inherited IRA throughout her 60s. This could enable her to wait until age 70 for Social Security, maximizing lifelong benefits, and perhaps providing a larger Social Security benefit for her husband Bob, if he survives her. Thus, someone who inherits an IRA before starting to collect Social Security should consider delaying Social Security and tapping the inherited IRA to meet living expenses in the interim.
What’s more, the Tax Cuts and Jobs Act is set to expire on 12/31/2025. It is unknown what tax rates will be effective in 2026 and beyond, but higher rates are scheduled. The 2024 and 2025 tax brackets are known, so Alice might take advantage of them by filling her current brackets both years at those rates by withdrawing from the inherited IRA. She might even be willing to spill over into the next tax bracket by taking larger withdrawals from her inherited IRA before 2026.
Year after year, tax bracket management is important. Consumers and their advisors can plan now under current tax rates and regroup when the new tax bracket information is known.
The two-year hitch
In our example, Alice has yet to reach age 63. Indeed, people who inherit an IRA before age 63 have still more planning to do. Someone’s MAGI at age 63 will be reported on a tax return filed at age 64 and used to set Medicare premiums at age 65. Each year, the process will be repeated, with Medicare premiums possibly increased two years in the future if MAGI tops certain thresholds.
Therefore, it may make sense for people holding inherited IRAs before age 63 to take greater-than required distributions each year, if they can remain in a modest tax bracket. That might reduce required distributions from age 73 and succeeding years, holding down MAGI and avoiding increases in Medicare premiums.
Peak problems
An inherited IRA might be received during the beneficiary’s prime working years, so RMDs from an inherited IRA may wind up compounding the regular income tax problem. Moreover, the added income could cause higher tax on Social Security benefits or higher Medicare premiums. One workaround may be available to a surviving spouse who does a spousal rollover from the inherited IRA to an IRA in his or her own name. Then the widow(er) can use this IRA money to buy a Qualified Longevity Annuity Contract (QLAC).
A QLAC is used to delay RMDs, deferring income as late as age 85. During the deferral period, money in a QLAC won’t count for RMD purposes. Later in life, when the QLAC is triggered, the IRA owner might be retired and in a lower tax bracket, with little or no earned income. However, a QLAC can’t be purchased in an inherited IRA.
Sweet charity
Another tax planning opportunity comes into play at age 70-1/2: that’s when IRA money can be used for Qualified Charitable Distributions (QCDs). Neither the original IRA owner’s age at death nor the beneficiary’s age at inheritance matters; the age of the donor at the time of the QCD is what counts.
With QCDs, money goes directly to qualified charities, with no taxable income reported for the distribution. (No charitable tax deduction is allowed.) Once age 73 is reached (age 75 for those who turn 74 after 2032), QCDs count towards required minimum distributions. In essence, QCDs allow people with pre-tax money in their IRAs to get a tax benefit—holding down taxable income—by using dollars that never have been taxed for desired donations.
At our firm, we focus on QCDs in the first quarter of each year, for seniors with philanthropic intent. In a calendar year when RMDs are due, the first dollars withdrawn will go to satisfy the RMD. Taxable RMD income can’t be offset by QCDs done later in that year.
Going the Roth route
If we focus on QCDs early in the year, what do we emphasize as the year draws to a close? In many cases, we suggest conversions from traditional to Roth IRAs. Towards yearend, we may have a good idea of what someone’s reported income might be and how many dollars can be converted in a moderate tax bracket. The issues that IRA beneficiaries might face—higher tax on Social Security benefits, higher Medicare premiums--will not matter if the beneficiaries inherit a Roth account instead. RMDs might apply, but they would be untaxed if coming from a qualified Roth IRA.
At any age, traditional IRA owners might consider partial Roth conversions if they can be executed at a reasonable tax rate. Then their beneficiaries can inherit a substantial Roth account that can provide untaxed cash flow, required on not. Any money still held in a pre-tax traditional IRA at death cannot be converted to the Roth side, so taxable money must be withdrawn, often leading to unwelcome tax on Social Security benefits and higher Medicare premiums.
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Advisor action plan:
[] Discover which clients have inherited IRAs.
[] Determine which type of beneficiary they are, and which RMD rules apply.
[] For those who are not yet on Social Security or Medicare, see what strategies might be used. They include executing tax-effective Roth IRA conversions, in order to leave tax-favored dollars to IRA beneficiaries, and tapping inherited IRAs to allow delaying Social Security as late as age 70.
[] Inform clients with substantial charitable intent about the advantages of QCDs. Once clients reach age 70-1/2, urge them to consider QCDs early in the year.
[] In general, high-income clients are most likely to gain by planning to avoid boosts in Medicare premiums while people with moderate income may be able to hold down taxes on Social Security benefits with astute tactics such as loss harvesting during market bottoms.