Estate Planning & Probate
Inherited IRA Pennsylvania | The Ten Year Rule and What It Costs Your Family
When you inherit an IRA from a parent or non-spouse, Pennsylvania inheritance tax applies to the account value under 72 P.S. § 9116, and federal law requires the account to be fully distributed within ten years of the original owner’s death. Every dollar that comes out of a traditional IRA is ordinary income taxed at your marginal rate. Most families find out what that combination costs after the estate is already closed and the distributions have already started.
The ten year rule does not require equal annual distributions. It requires the account be empty by year ten. Every year you wait to plan the drawdown is a year of optimization runway you cannot recover.
The inherited IRA problem affects two different people. The parent who has built significant retirement savings and wants to understand what happens to those accounts after death, and whether planning now changes the outcome for their children. And the adult child who just inherited an IRA, just learned about the ten year rule, and wants to understand the options before more distributions happen without a strategy. The planning conversation is different depending on which situation you are in. The underlying problem is the same.
An inherited IRA with no distribution strategy will be fully taxed within ten years regardless. The question is whether the tax hits efficiently or at the worst possible rate in the worst possible years.
If you have inherited an IRA or want to understand what your IRA means for your children, call 412-351-4422 or contact our office to discuss your situation.
What the Ten Year Rule Actually Requires
The ten year rule requires most non-spouse beneficiaries to fully distribute an inherited IRA within ten years of the original owner’s death. The flexibility is in when and how much to take each year. The deadline is fixed.
Most non-spouse beneficiaries who inherit an IRA must fully distribute the account within ten years of the original owner’s death. The ten year rule does not require annual distributions. It requires the account be empty by December 31 of the tenth year after the year of death. A beneficiary can take nothing for nine years and everything in year ten, or spread distributions evenly, or concentrate them in lower-income years. The flexibility is real. The deadline is not.
The ten year rule applies to most non-spouse beneficiaries of traditional IRAs and 401k accounts. Exceptions exist for eligible designated beneficiaries, a defined category that includes surviving spouses, minor children of the original owner (until they reach the age of majority), disabled or chronically ill individuals, and beneficiaries who are not more than ten years younger than the original owner. If you fall into one of those categories, different rules may apply and the ten year clock may not govern your distributions at all. If you do not fall into those categories, the ten year rule applies and the planning question is how to optimize the distributions within that window rather than whether the window exists.
The Tax Problem: Every Dollar Is Ordinary Income
A traditional IRA holds pre-tax dollars. The original owner received a deduction when the money went in and deferred the tax on growth for decades. When a beneficiary takes distributions, every dollar that comes out is ordinary income in the year it is distributed, taxed at the beneficiary’s marginal federal rate plus any applicable state income tax. Pennsylvania does not tax retirement income for Pennsylvania residents, but a beneficiary who lives in a state that taxes retirement income, or who has other significant income in the distribution year, faces the full federal and state income tax hit on every inherited IRA dollar.
The size of the problem depends on the size of the account and the beneficiary’s other income. A Pittsburgh physician who inherits a $600,000 IRA from a parent and is already earning $350,000 per year will push significant distributions into the 37 percent federal bracket if distributions are not timed carefully. A sibling who is retired and living on Social Security and modest investment income has a much lower marginal rate and can absorb larger distributions with lower tax impact. The ten year rule applies to both but the tax cost is dramatically different depending on when and how much each takes each year.
Pennsylvania Inheritance Tax on Inherited IRAs
Pennsylvania inheritance tax applies to inherited IRA accounts regardless of when distributions are taken. Under 72 P.S. § 9116, transfers to children and lineal descendants are taxed at 4.5 percent. The inheritance tax is calculated on the fair market value of the IRA at the date of death, not on the distributions as they are taken. That means the 4.5 percent inheritance tax is owed on the full account value within nine months of death, before most beneficiaries have taken a single distribution. Cash flow planning for the estate must account for both the inheritance tax payment on the IRA and the income tax that will be owed as distributions come out over the following ten years.
Transfers to a surviving spouse are exempt from Pennsylvania inheritance tax under 72 P.S. § 9111. A surviving spouse who rolls an inherited IRA into their own IRA avoids the ten year rule entirely and is treated as the original owner of the account. That is a significant benefit that non-spouse beneficiaries do not have. The surviving spouse’s own beneficiaries, typically children, will eventually face the ten year rule when they inherit from the surviving spouse, but the tax is deferred until that second death.
Most IRAs pass to beneficiaries by beneficiary designation outside the probate estate. The account transfers directly to the named beneficiary without going through the executor. That is clean and fast. But it creates a liquidity problem that executors discover at the nine month deadline: the IRA went directly to the beneficiary, but the estate still owes Pennsylvania inheritance tax on the full account value. The beneficiary received the asset. The estate must pay the tax from whatever other assets are available. An estate that consists primarily of a large IRA with little else, no bank accounts, no liquidatable investments, may not have the cash to pay the 4.5 percent inheritance tax without the executor requesting distributions from the beneficiary or petitioning the court. That mismatch should be anticipated in estate planning and addressed before death, not discovered nine months after it.
The Planning Runway: What Changes When You Find Out Early
The ten year window does not require action in any particular year, but every year without a distribution strategy is a year of optimization runway that cannot be recovered. A beneficiary who takes large distributions in high-income years early and smaller ones later has already locked in the higher tax rate on those early dollars. Year one distributions cannot be undone. Year three distributions cannot be undone. The planning question is always: given what I know about my income this year and my projected income over the next ten years, when is the least expensive time to take these distributions?
Factors that affect the optimal distribution schedule include the beneficiary’s current marginal tax rate, projected retirement date and income changes, other income sources including Social Security timing, other inherited assets being distributed simultaneously, and whether the beneficiary has other tax losses or deductions that could offset IRA income in specific years. None of those factors are static. A distribution strategy built in year one should be reviewed every year as circumstances change.
What this looks like in practice: A Pittsburgh couple in their early sixties inherited a $740,000 traditional IRA from the wife’s mother. Both spouses were still working. Their combined income before any IRA distributions was approximately $280,000. In year one they took no distributions, not knowing there was a strategy to consider. In year two their financial advisor mentioned the ten year rule. They had eight years left. A CPA modeled the distribution schedule and identified that the wife planned to retire at 65, reducing household income by approximately $120,000 per year. Concentrating the bulk of distributions in years four through eight, after retirement and before required minimum distributions from their own IRAs began at 73, reduced the projected total income tax on the inherited IRA by approximately $67,000 compared to taking equal distributions each year. Year one was already gone. Two years of the runway had been used without a plan.
What the Original Owner Can Still Do
For Pittsburgh families where the IRA owner is still alive, the most impactful planning tool is a Roth conversion. Converting a traditional IRA to a Roth IRA during the owner’s lifetime means the owner pays income tax on the converted amount now, at their current rate. After conversion, the Roth IRA grows tax-free and distributions to beneficiaries are tax-free. Beneficiaries still face the ten year rule on an inherited Roth IRA, but distributions from a Roth are not income in the year taken. The conversion shifts the tax burden from the beneficiaries’ high-earning years to the owner’s retirement years, which are often lower-income years where the conversion tax is less costly.
A Roth conversion is a taxable event under I.R.C. § 408A: the converted amount is ordinary income in the year of conversion. It is also irrevocable. A conversion that proves disadvantageous in hindsight cannot be undone. Whether a Roth conversion makes sense depends on the owner’s current tax rate, projected future rates, the size of the IRA, the owner’s age and life expectancy, and the beneficiaries’ likely income levels when they inherit. The right answer for one family is the wrong answer for another. The analysis requires modeling the full picture across the owner’s remaining lifetime and the beneficiaries’ ten year distribution window. That is a joint conversation between an estate planning attorney and a CPA or financial advisor, not a decision made from a general explanation.
When the Beneficiary Is a Trust
Some Pittsburgh families name a trust as the IRA beneficiary rather than individuals. The rules governing trust beneficiaries of IRAs are more complex and the ten year rule applies differently depending on whether the trust qualifies as a see-through trust with identifiable individual beneficiaries. A trust that does not qualify as a see-through trust is subject to the five-year rule under I.R.C. § 401(a)(9)(B)(ii), requiring full distribution within five years of the owner’s death. There is no ten year window for a non-qualifying trust. Naming a trust as an IRA beneficiary is sometimes the right answer in situations involving a beneficiary with a disability, a beneficiary with creditor problems, or a situation where the original owner wants more control over distributions. But it requires careful coordination between the IRA beneficiary designation and the trust terms, and it should be reviewed by counsel who understands both the IRA rules and the trust structure.
Frequently Asked Questions
Do I have to take distributions every year from an inherited IRA?
For most non-spouse beneficiaries, no. The ten year rule requires the account be fully distributed by December 31 of the tenth year after the original owner’s death, but it does not require annual distributions within that window. You can take nothing for several years and distribute the full amount in year ten, or spread distributions however makes sense for your tax situation. There are exceptions for original owners who had already begun required minimum distributions before death. In those cases the beneficiary may need to take annual distributions based on their life expectancy, in addition to emptying the account by year ten.
Does Pennsylvania tax inherited IRA distributions?
Pennsylvania does not tax retirement income for Pennsylvania residents. Distributions from an inherited IRA to a Pennsylvania resident are not subject to Pennsylvania income tax. However, Pennsylvania inheritance tax applies to the fair market value of the IRA at the date of death: 4.5 percent for children and lineal descendants, 12 percent for siblings, 15 percent for others. That inheritance tax is owed within nine months of death regardless of when distributions are taken, and it is calculated on the full account value, not the after-income-tax value.
What if I am the surviving spouse? Do the ten year rules apply to me?
No. A surviving spouse has the option to roll an inherited IRA into their own IRA and be treated as the original owner. That eliminates the ten year rule entirely. The surviving spouse’s own required minimum distribution rules apply, but the inherited account is no longer subject to the ten year clock. When the surviving spouse eventually dies and leaves the IRA to the next generation, the ten year rule will apply to those beneficiaries at that point.
Can I disclaim an inherited IRA I do not want?
Yes. A beneficiary can disclaim an inherited IRA within nine months of the original owner’s death, and the account will pass as if the disclaiming beneficiary had predeceased the owner. A disclaimer can make sense when the primary beneficiary is in a high tax bracket and a contingent beneficiary such as a younger child or grandchild is in a lower bracket. A qualified disclaimer under 26 U.S.C. § 2518 must meet specific requirements including that the beneficiary has not accepted any benefit from the account before disclaiming. Disclaiming has permanent consequences and should be evaluated with tax and estate planning counsel before the nine-month window closes.
What happens if I miss the ten year deadline?
Any amount remaining in an inherited IRA after the ten year deadline is subject to a 25 percent excise tax under federal law. That excise tax is in addition to ordinary income tax on the distribution. The penalty can be reduced to 10 percent if corrected within two years. Missing the ten year deadline is an expensive mistake on a large IRA. The ten year clock starts on January 1 of the year following the original owner’s death, so the deadline is December 31 of the tenth year after the year of death.
Should my parent convert their IRA to a Roth before they die?
It depends on the full picture. A Roth conversion shifts the tax burden from the beneficiaries to the original owner, who pays income tax on the converted amount now at their current rate. If the owner’s current rate is lower than the beneficiaries’ likely rates during the ten year distribution window, the conversion makes economic sense. If the owner’s current rate is higher, or if the owner does not have non-IRA assets to pay the conversion tax without depleting the retirement account, the conversion may not be beneficial. Whether a Roth conversion makes sense requires modeling the owner’s remaining lifetime and the beneficiaries’ projected income during the distribution window.
For more information on estate planning in Pennsylvania, visit our Estate Planning and Probate practice area page.