Many Americans work hard their entire lives aiming to build a seven-figure retirement nest egg. But what happens if you’re lucky enough to inherit one? Do the rules change?
Imagine 25-year-old Candace, who just lost a favorite uncle at 70. He had no children of his own and left behind a Roth IRA worth $1.5 million to her. She’s not sure what to do — she has some debt, but also wants to buy a house and maybe take a bucket-list trip to Italy.
With such a big windfall, it’s important to make sure you understand the rules that apply and how taxes might impact the total amount.
Before Candace spends a dime, she needs to understand how the IRS treats inherited retirement accounts because the rules vary depending on the relationship you have with the deceased.
Since Candace is her uncle’s niece, she’s considered a non-spouse beneficiary. Under the SECURE Act, passed in 2020, most non-spouse beneficiaries are required to fully withdraw the inherited account within 10 years of the original owner’s death (1). There are no mandatory annual withdrawals during that window, but the account must be emptied by the end of year 10.
The good news for Candace is Roth IRA withdrawals will generally be tax-free, as long as the account was at least five years old at the time of her uncle’s death. That’s a significant advantage over inheriting a traditional IRA, where every dollar withdrawn is taxed as ordinary income. Withdrawals also won’t be subject to the 10% early withdrawal penalty.
That said, the 10-year clock creates some pressure. If Candace does nothing and waits until year 10 to withdraw everything, she’ll receive a giant lump sum — tax-free in her case, but a massive financial event regardless. Spreading withdrawals across the 10 years can give her more control and flexibility.
It’s also worth noting that inherited Roth IRA funds can’t be rolled over into her own existing Roth IRA. The accounts must stay separate. However, she can withdraw the money and use it to fund her own accounts.
It’s worth noting, however, the tax liability for inherited retirement accounts can get complicated. Consult with a tax professional for advice on your specific situation.
Read More: 5 essential money moves to make once you’ve saved $50,000
Read More: Young millionaires are ditching stocks. Why older Americans should take note
Inheriting a $1.5 million retirement account can be life-changing, but if you misuse the funds they can disappear faster than you think. If you received a large inheritance, here are some steps to consider taking.
Take your time: Grief and deep pockets can be difficult to manage simultaneously. Before spending anything, consider giving yourself a waiting period, ideally six months to a year, before making any major moves. In Candace’s case, the 10-year withdrawal window gives her time to plan, so there’s no reason to rush.
Talk to a financial advisor: An inheritance of this size warrants professional guidance. A fiduciary advisor is legally required to act in a client’s best interest, unlike a broker, who may recommend products that earn them a commission. A fiduciary can help you build a withdrawal strategy, figure out if you’ll owe taxes and spell out how to make these funds work for you. (5)
Pay off your debt: There’s no need to let debt drag you down anymore. Prioritize paying down high-interest debt, such as credit card debt, as it can do the most damage. Holding on to debt will only cost you more money as time drags on.
Make sure you have a solid emergency fund: Before putting money toward wants, make sure you have three to six months’ worth of living expenses set aside in a liquid account, such as a high-yield savings account. This will shield you in case of an emergency while preventing you from going (further) into debt.
Secure your retirement: If you’re young, it might seem counterintuitive to focus on retirement right now, but time is on your side. The longer your retirement savings have to grow, the better off you’ll be. While you can’t roll your inheritance into your IRA or 401(k), you can use the withdrawals to help fund the IRA or cover expenses while you max out your 401(k) contribution.
Once you have your ducks in a row, it’s entirely reasonable to want to enjoy newfound riches. Whether it’s a trip to Italy or a down payment on a home, spending on wants isn’t irresponsible — just make sure your financial foundation is solid first.
Join 250,000+ readers and get Moneywise’s best stories and exclusive interviews first — clear insights curated and delivered weekly. Subscribe now.
We rely only on vetted sources and credible third-party reporting. For details, see our editorial ethics and guidelines.
IRS (1)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
Leave a Reply