1 IRA Rule That Could Turn Into a Financial Mess

As difficult as it may be to consider an inheritance a pain in the pocketbook, it can be. One example involves the relatively new 10-year rule for inherited IRAs and how it can create a tax time bomb.

Exempt beneficiaries

Before diving in, here are five groups of beneficiaries exempt from the 10-year rule:

• Surviving spouses,
• Minor children of the original account owner,
• Disabled recipients,
• Chronically ill recipients, and
• Beneficiaries not more than 10 years younger than the original IRA owner

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What's the 10-year rule (in a nutshell)?

The 10-year rule applies to those who inherit an IRA from someone who passed away after Dec. 31, 2019. It requires most beneficiaries of an IRA to withdraw the funds within 10 years of the original owner's death. Rather than allow the funds in the retirement account to grow, recipients must ensure that the account is empty when the 10-year deadline arrives.

While an entire decade may sound like a reasonable amount of time to strategically withdraw the money, the details that make up the 10-year rule may prove otherwise.

Issue No. 1: Annual RMDs or a simple 10-year deadline?

At a glance, the rule appears to indicate that beneficiaries can simply empty the account by the end of the tenth year, and that's correct -- to a point. The truth depends on whether the original account-holders had already begun taking required minimum distributions (RMDs) before they died.

If that's the case, nonexempt beneficiaries of their IRA must continue taking annual distributions. If beneficiaries don't know they're supposed to take an annual distribution (and fail to do so), they could face a 25% penalty for the funds that weren't distributed. For example, a person who missed a $10,000 withdrawal could end up paying a $2,500 penalty.

Issue No. 2: A potential tax bomb

Before the 10-year rule, beneficiaries could stretch withdrawals over their life expectancy, a practice that made tax planning easier. By compressing the distribution timeline to 10 years, the 10-year rule forces IRA beneficiaries to withdraw larger amounts, potentially resulting in larger-than-expected tax bills.

Since IRA distributions count as income, larger withdrawals may also trigger a substantial increase in Medicare premiums for retirees and lead to the loss of specific tax credits and deductions they would otherwise be eligible for.

Issue No. 3: Planning challenges

The 10-year rule adds an extra layer of complexity to financial planning. That's because you must plan around every other major income event in your life, including selling a business or real estate, receiving a bonus at work, and exercising stock options. And if you're in your peak earning years when the 10-year clock begins, adding money to your already high income can push you into a tax bracket you were hoping to avoid.

There's nothing negative about someone caring about you enough to name you as a beneficiary. The point is, inheriting an IRA may be more complex than you expected, and working with a financial planner who can help you minimize your tax burden could be worth its weight in gold.

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