Inheriting an IRA? Advisors warn these 3 costly mistakes could drain far more of your windfall than you expect

Of that, charities are expected to receive about $18 trillion while Gen X and millennial heirs will receive the bulk: $105 trillion.

Along the way, $54 trillion will be passed on to spouses before moving on to the next generation.

Since the average IRA account balance for Americans aged 61 to 79 is $257,002 (2), it seems likely that some of this wealth transfer will come from these accounts. But if you’re a non-spouse heir, there are some common mistakes you should be aware of.

1. Not knowing the rules for inheriting an IRA

The IRS has a lot of complex rules around non-spouse heirs inheriting an IRA. Failing to understand and adhere to those rules can result in paying more taxes than you need to and, perhaps worse, substantial penalties.

If you’re inheriting an IRA, it’s worth talking to a qualified financial advisor who’s familiar with the latest updates to these rules.

For example, there are different rules if the deceased died before 2020, which may be relevant if you’ve been trapped in probate purgatory. If you want to get a quick overview, the IRS provides a summary of the rules on its website.

One of the most important of these is the “10-year rule,” which applies to beneficiaries who are not considered “eligible designated beneficiaries.” The deceased’s spouse is an eligible designated beneficiary, as well as a minor child.

An adult child is typically not considered an eligible designated beneficiary, which means they have to empty the IRA by the end of the 10th year after the account owner’s death.

Additionally, if the deceased plan holder died after they were required to make required minimum distributions (RMDs) — which, for IRAs, are required from April 1 of the year after the account holder turns 73 — the beneficiary must also make RMDs or face penalties of up to 25% of the value of the missed RMD.

However, this can be reduced to 10% if the RMD is corrected within two years of the missed payment and you submit a Form 5329 to the IRS.

2. Neglecting tax planning

When you inherit an IRA that requires regular withdrawals, you’ll have additional income each year, so you’ll want to determine the most efficient withdrawal strategy for tax purposes.

For example, some beneficiaries choose to only take the RMDs and end up with a large remaining balance in year 10, which then leads to a substantial tax bill that year. Similarly, you will likely want to avoid cashing out the full account when you first inherit it.

Tax planning may need to be a dynamic and ongoing process. For example, if your income is inconsistent or you experience a one-off decline or increase in income, you’ll want to adjust your distributions accordingly.

Poor tax planning can be costly, so you may want to speak with an advisor who can run scenarios and optimize your strategy.

3. Not reviewing investments in the inherited IRA

The investments in the IRA are now yours and it’s unlikely they’re all suitable for you. When you inherit an IRA you’ll want to evaluate and alter the holdings based on your risk tolerance and goals (which an advisor can help with).

Not optimizing the new portfolio can potentially keep you from earning as much as you can on your new windfall.