Liquidating an inherited IRA

An Individual Retirement Account (IRA) is designed to help individuals save for retirement, but when the original account owner dies, the beneficiaries must figure out what to do with retirement assets. One of the decisions that beneficiaries must make is whether to liquidate the inherited IRA or manage distributions over time.

If you inherited an IRA, you can choose to liquidate the IRA at any time. You can decide to liquidate the inherited IRA immediately by taking a lump sum distribution, or by spreading distributions based on the 10-year rule to avoid being pushed to a higher tax bracket. Keep in mind that liquidating an inherited IRA can mean taking large distributions, which can trigger significant tax liabilities.

Can you liquidate an inherited IRA without penalty?

Individuals who inherit an IRA are not subject to the 10% early withdrawal penalty that applies to withdrawals taken from a traditional IRA before age 59 ½. This means you can withdraw money from the inherited IRA at any time without worrying about the early withdrawal penalty, even if you are younger than 59 ½. 

However, while you won't owe an early withdrawal penalty on the money, distributions from an inherited IRA are considered taxable income and are subject to income taxes at your tax bracket rate. For example, if the total income, including inherited IRA distributions, pushes you to the 30% income tax bracket, you will pay more taxes during the tax year.

Tax consequences of inheriting a traditional IRA

Traditional IRAs are funded with pre-tax dollars, meaning that the original IRA holder did not pay income taxes on contributions or earnings generated over the years. However, any withdrawals taken from a traditional IRA will be subject to income taxes at your tax bracket.

If you inherited a traditional IRA, you will be responsible for paying income taxes on the withdrawals you make. If you take a sizeable distribution from the inherited IRA that is enough to lift you to a higher tax bracket, you may owe more income taxes on your other incomes as well.

Fortunately, inherited IRAs enjoy some special treatment. You won’t be required to pay an early withdrawal penalty that is ordinarily charged on early withdrawals made from a traditional IRA. Therefore, inherited IRA beneficiaries won’t be required to pay early withdrawal penalties, even if they are below age 59 ½.   

Tax Consequences of Inheriting a Roth IRA

Qualified distributions taken from a Roth IRA have a different tax treatment compared to traditional IRAs. Since a Roth IRA is funded with post-tax dollars, any qualified distributions taken from the account are generally tax-free.

A Roth IRA distribution is considered qualified if the money has been in the Roth IRA for at least five years, including the period when the original account owner was alive. However, if the funds were held for less than five years, the distributions will be considered unqualified, and hence subject to income taxes.

Keep in mind that inherited Roth IRAs are subject to the 10-year rule, meaning that you must take the full distribution from the account by the 10^th year since the original account owner’s death.

What to know about the 10-year rule

The 10-year rule for inherited IRAs applies to non-eligible designated beneficiaries who inherited an IRA on January 1, 2020, or later. It requires beneficiaries to empty the inherited IRA by the 10^th year after the original IRA owner’s death. Non-eligible beneficiaries include non-spouse heirs such as parents, adult children, etc.

While beneficiaries are required to deplete the inherited IRA within 10 years, they are not required to take annual distributions. Beneficiaries have the flexibility to take distributions at any time and in any amount, as long the retirement account is fully distributed by the 10^th year.

Certain beneficiaries are exempted from the 10-year rule. These beneficiaries include surviving spouses, minor children, disabled or chronically ill beneficiaries, and individuals who are no more than 10 years younger than the original IRA account holder. These beneficiaries can spread distributions based on their life expectancy. However, minor children lose this exception once they attain the age of majority, and will be subject to the 10-year rule once they reach age 21.

Penalties for non-compliance

Beneficiaries who are subject to the 10-year rule must fully withdraw the inherited IRA by December 31st of the 10^th anniversary of the account owner’s death. Failure to empty the retirement account within the required time could result in penalties as high as 25% of the distributions not taken, or 10% if you correct the error within 2 years.

Due to the confusion created by the SECURE Act, the IRS waived penalties for some beneficiaries who inherited an IRA but missed RMDs from 2020 to 2023, and the waiver period runs until 2025. Once the waiver period ends, beneficiaries will still be required to deplete the inherited IRA within 10 years from the death of the original IRA owner.

Beneficiaries may want to start taking RMDs to avoid bigger mandatory distributions in the future.

Can I close my inherited IRA?

You may be able to close your inherited IRA, but you must withdraw the entire IRA balance and liquidate the account. However, be aware that withdrawing the full balance can have immediate tax implications. If you decide to close and cash out the entire distribution, the amount will be treated as income in the year of distribution. If the distribution is large enough, it can result in a substantial tax bill.