What to do with an Inherited IRA

Inheriting an IRA is very common financial event that families face, yet it is also one of the most misunderstood.

Almost everyone will deal with an inherited IRA at some point, whether from a spouse, parent, or other loved one. IRAs, 401ks, and Roth accounts are some of the most widely held assets today. And since none of us get out of here alive, these accounts almost always pass to someone else.

Yet despite how common inherited IRAs are, they remain one of the top topics we discuss with clients on a daily basis. The rules have changed. The tax implications can be significant. And the decisions you make, or fail to make, can quietly cost you hundreds of thousands of dollars over time.

The good news is this: Inheriting an IRA is a good problem to have. It means someone cared enough to leave you something meaningful. But like many good problems, it still needs to be solved thoughtfully.

Today will walk through how inherited IRAs work, the differences between Roth and traditional inherited IRAs, the 10-year rule, common mistakes to avoid, and why planning matters more than ever.

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Why Inherited IRAs Deserve Special Attention

For many families, an inherited IRA is not a small account. It can easily be several hundred thousand dollars or more. In some cases, it is the largest asset someone inherits. What makes inherited IRAs tricky is that the rules are very different depending on who you are, what type of account you inherited, and when the original owner passed away.

If you treat an inherited IRA like a regular investment account, you can end up with unexpected tax bills, forced distributions at the worst possible time, or missed planning opportunities.

This is why inherited IRAs are not something you want to handle on autopilot.

The Two Types of Inherited IRAs

At a high level, there are two types of inherited IRAs you can receive:

1. An inherited Roth IRA

2. An inherited traditional IRA or inherited 401(k)

While they share a name, they behave very differently. Understanding which one you inherited is the first and most important step.

Inherited Roth IRAs: The Simpler Side

Let’s start with inherited Roth IRAs because they are far easier to understand and manage.

How Roth IRAs Work

A Roth IRA is funded with after-tax dollars. The original account owner already paid taxes on the money that went in. As a result, the money grows tax free.

Roth IRAs are not subject to required minimum distributions during the original owner’s lifetime. That alone makes them one of the most powerful long-term planning tools available.

If You Inherit a Roth IRA as a Spouse

If you inherit a Roth IRA from your spouse, the process is simple. The account rolls into your own Roth IRA.

There are no required minimum distributions. There is no complicated rule set to follow. It becomes your account, and you can continue to let it grow tax free.

This is one of the cleanest transitions in financial planning.

If You Inherit a Roth IRA as a Non-Spouse

If you are not the spouse, which includes children, grandchildren, siblings, or anyone else, you fall under what is known as the 10-year rule. This rule requires that the inherited Roth IRA be fully depleted within 10 years of the original owner’s death.

Here is the key point. There is no required annual distribution. You can take out as much or as little as you want in any given year, as long as the account is fully emptied by the end of year 10.

A Common and Often Optimal Strategy

For most people who do not need the money immediately, the simplest strategy is to let the inherited Roth IRA grow untouched for the full 10 years.

Since the money continues to grow tax free, allowing it to compound for as long as possible often makes sense. At the end of year 10, you withdraw the entire balance and move it into an individual or joint investment account.

There is no tax bill when you do this. That is the beauty of a Roth.

If you need the money earlier, you can access it at any time without penalty or taxes. There are no restrictions forcing you to wait. This flexibility is why Roth IRAs are such a powerful asset to inherit and why we encourage people to fund Roth accounts whenever possible.

Inherited Traditional IRAs: More Moving Parts

Now let’s move to the inherited traditional IRA or inherited 401(k). This is where planning becomes critical.

How Traditional IRAs Work

Traditional IRAs and 401(k)s are funded with pre-tax dollars. The original account owner received a tax deduction when the money went in. The account then grew tax deferred.

Taxes are owed when the money comes out.

When you inherit one of these accounts, the tax bill does not disappear. It simply transfers to you.

If You Inherit a Traditional IRA as a Spouse

Just like with a Roth, if you inherit a traditional IRA from your spouse, the process is relatively simple.

The account rolls into your own IRA. From there, it follows the normal required minimum distribution rules based on your age.

This is usually straightforward and does not require special strategies beyond normal retirement planning.

If You Inherit a Traditional IRA as a Non-Spouse

This is where most mistakes happen.

As a non-spouse beneficiary, you are subject to the 10-year rule. The account must be fully depleted within 10 years.

Unlike an inherited Roth IRA, every dollar you withdraw from a traditional inherited IRA is taxed as ordinary income at your current tax rate.

This is where the real planning challenge begins.

Understanding the Tax Impact

Let’s look at a simple example.

Assume you earn $150,000 per year. You inherit a traditional IRA and decide to take out $50,000 this year.

Your taxable income is now $200,000.

That additional income could push you into a higher tax bracket, increase your state taxes, and potentially trigger other consequences like higher Medicare premiums later in life.

Now imagine inheriting a $1 million IRA.

If you wait too long and are forced to withdraw the entire balance in the final year, that million dollars is added on top of your regular income in a single year.

That is a tax bill almost no one enjoys paying.

The Mistake of Only Taking Required Minimum Distributions

If the original account owner was already subject to required minimum distributions, those RMDs continue in the inherited IRA.

Here is the issue. Taking only the RMDs does not satisfy the 10-year rule.

The math simply does not work.

You could take RMDs every year and still be left with a large balance at the end of year 10. At that point, you are forced to withdraw everything remaining, regardless of tax consequences.

This is one of the most common mistakes we see.

The “One-Tenth Per Year” Strategy and Its Limitations

Some people attempt a simple approach by withdrawing one-tenth of the account each year. While this feels logical, it has a hidden flaw.

The account is still invested. If the portfolio grows at a similar rate to your withdrawals, the balance may not meaningfully decline. You could reach year 10 and still be staring at a large taxable balance that must be distributed all at once.

This is why inherited IRAs require more than a simple formula.

Why Timing Matters More Than Amount

With inherited traditional IRAs, timing is often more important than how much you withdraw.

The goal is not just to empty the account. The goal is to do so in a way that minimizes taxes over the full 10-year period.

That may mean taking larger distributions in lower-income years. It may mean spreading withdrawals unevenly. It may mean coordinating withdrawals with retirement, a business sale, or other life events.

There is no one-size-fits-all solution.

Medicare Premiums and Other Hidden Consequences

For those approaching or already on Medicare, inherited IRA distributions can impact more than just income taxes. Higher income can increase Medicare Part B and Part D premiums through what is known as IRMAA surcharges.

These premium increases are often overlooked, but they can significantly raise healthcare costs for years. This is another reason careful planning matters.

Qualified Charitable Distributions as a Strategy

Inherited traditional IRAs still allow for qualified charitable distributions, or QCDs, once you reach age 70 and a half. A QCD allows you to donate directly from your IRA to a qualified charity. The amount donated is not included in your taxable income. This can be a powerful tool for those who are charitably inclined and in higher tax brackets.

However, eligibility depends entirely on your age when you inherit the IRA. If you inherit it earlier in life, this option may not be available. It is very much a matter of timing and circumstance.

Why You Should Not Wait Until Year 10

One of the biggest mistakes we see is inaction.

People inherit an IRA, feel overwhelmed, and decide to deal with it later. Before they know it, several years have passed. Waiting until the final year almost guarantees a painful tax outcome.

Planning early gives you flexibility. Waiting removes it.

Estate Planning and Beneficiary Designations Matter

Inherited IRAs are also a reminder of how critical beneficiary designations are. These accounts pass by beneficiary designation, not by your will.

If beneficiaries are outdated, incorrect, or incomplete, the money may not go where you intended. And once the original owner passes, there is usually nothing that can be done to change it.

We recommend reviewing beneficiaries at least annually or anytime a major life event occurs. Divorces, remarriages, births, deaths, and family changes all warrant a review. This small administrative step in your estate planning can prevent significant family conflict later.

Making a Difficult Situation Easier

Losing a loved one is already hard. Financial confusion should not add to the burden.

While inherited IRAs can feel complex, the goal of planning is simple. Make a difficult situation as easy and tax-efficient as possible.

With the right strategy, inherited IRAs can be managed thoughtfully and responsibly. Without one, they can quietly create unnecessary stress and taxes.

The Bottom Line

Inherited IRAs are common. Mishandling them is also common. Roth inherited IRAs are generally straightforward and flexible. Traditional inherited IRAs require careful, proactive planning. The 10-year rule changed the landscape, and the old strategies no longer work the way they used to. Doing nothing is rarely the right move.

If you have inherited an IRA, or expect to, this is an area where working with a financial advisor and a tax professional is not just helpful, it is essential.

If you want help evaluating your situation and building a plan that fits your life, your income, and your goals, we are always here to help. At Bonfire Financial, our goal is simple. Help you make smart decisions so you can retire the way you want, without paying more in taxes than necessary.

Give us a call today to get help with your inherited IRA.