Since the creation of the 401(k) under the Revenue Act of 1978, workers have been encouraged to save for retirement. By deferring a portion of each paycheck, many built meaningful savings – often with employer matches – invested and growing tax-deferred over time. Others contributed to IRAs or SEP plans, steadily accumulating a nest egg to support their future.
For decades, the playbook was straightforward. These assets grew without immediate taxation, and in retirement, individuals would begin withdrawing funds, taking required minimum distributions (RMDs) and naming spouses, children, or other loved ones as beneficiaries. The expectation was that those beneficiaries could continue stretching those assets over their own lifetimes.
That changed with the introduction of the SECURE Act of 2019. The rules around inherited retirement accounts shifted significantly, making it more important than ever to understand the tax implications and explore strategies to reduce the burden – for both account owners and the next generation.
When a non-spouse inherits an IRA, they must move the assets into an inherited IRA rather than treating the account as their own. This preserves the tax-advantaged status of the funds, but it also triggers specific distribution requirements. Most notably, the SECURE Act introduced the “10-year rule,” which requires most non-spouse beneficiaries to fully withdraw the account balance within ten years of the original owner’s death.
While this rule provides flexibility in timing withdrawals, it also creates a potential tax challenge. Distributions from a traditional IRA are taxed as ordinary income, meaning they are added to the beneficiary’s taxable income in the year they are taken. If the inherited IRA is substantial, withdrawing large amounts in a single year could push the beneficiary into a significantly higher tax bracket, increasing the overall tax paid on the inheritance.
For example, your beneficiaries, who are in their peak earning years, may already be in a higher tax bracket than you are. Adding large IRA distributions on top of their salary could result in a higher marginal rate, effectively eroding a sizable portion of the inherited funds. This makes withdrawal strategy a critical component of tax planning.
Roth conversions can be a powerful strategy, especially in years when the account owner’s income is lower or when tax rates are expected to rise in the future. By gradually converting portions of a traditional IRA to a Roth IRA, the tax impact can be managed over time while reducing the eventual burden on beneficiaries.
Roth IRAs present a different tax scenario. Although non-spouse beneficiaries are still subject to the 10-year rule, qualified withdrawals from a Roth are generally tax-free. This can provide significant tax advantages, particularly if the account has experienced substantial growth. Because of this, some account owners choose to convert traditional IRAs to Roth IRAs during their lifetime, paying the taxes upfront in exchange for tax-free distributions for their heirs.
Another strategy to consider is charitable giving. For individuals with philanthropic goals, naming a qualified charity or donor advised fund as the beneficiary of an IRA can be highly tax efficient. Because charities do not pay income tax, they can receive the full value of the IRA without the reductions that individual beneficiaries would face. Meanwhile, other assets—such as taxable investment accounts that may benefit from a step-up in basis can be passed to heirs. If you are charitable, you can also consider making Qualified Charitable Distributions (QCDs) directly to a charity as part of your RMD planning while you’re still living.
Ultimately, passing down an IRA to a non-spouse beneficiary requires careful coordination between estate planning and tax strategy. What may seem like a straightforward inheritance can quickly become complex without proper planning. By understanding the tax implications and considering strategies such as Roth conversions, charitable giving, and thoughtful withdrawal timing, account owners can help ensure that more of their hard-earned savings reaches the people and causes they care about most.
This combination of estate, charitable and tax planning are at the heart of what we do for our clients at LeConte Wealth. We help our clients protect the retirement nest egg that they’ve created, define a purpose for what they want to accomplish, and implement a plan that helps them realize their goals and pass along their wealth to future generations in the most efficient way possible.
