A Professional Guide for Beneficiaries and Families
Can an inherited IRA really be taxed up to 94.1%, and how do you avoid that outcome? What is the 10-Year Rule under the SECURE Act, and why does it threaten your IRA inheritance? What is an IRA inheritance trust, and how can it protect your legacy from excessive taxes?
If you’re preparing to leave an IRA to a loved one or expect to inherit one, attention to detail is crucial. The world of inherited IRAs is fraught with pitfalls, particularly as tax laws evolve and grow more complex. In recent years, federal policy and state treatment—especially in tax-aggressive climates such as California—have combined to create what we refer to, only half-jokingly, as the “IRA tax apocalypse.” This article provides expert guidance to help you navigate this landscape with an informed and deliberate approach.
The 94.1% Tax Trap: An Unwelcome Surprise
If you’re not careful, taxes on an inherited retirement account can take away up to 94.1% of its value. This can happen because of a combination of Federal Estate Tax, state and federal income taxes, and it can cause other extra taxes.
The SECURE Act 2.0’s 10-Year Rule also requires most people to withdraw all the money within ten years, which can result in significant tax bills.
It’s tempting to say, “It can’t happen to me,” but I regularly meet clients who are shocked to discover that the government’s bite is far larger than anticipated.
Let’s look at a hypothetical: Blair inherits a $500K IRA in California. If Blair waits the full ten years so it can grow to $1M and then withdraws the entire amount at once, that money gets added to Blair’s income for that year, pushing Blair into the highest tax brackets.
After paying about 40% in Federal Estate Tax, up to 37% in federal income tax, 13.3% in state income tax, and 3.8% Net Investment Income Tax, Blair could lose almost everything to taxes—keeping less than $100,000 from the original $1 million.
This example shows why it’s so important to plan ahead and work with professionals to avoid a huge tax bill.
Income Taxes: California and Federal Income Taxes
Think about how a Big Mac is made up of several different layers—a bun, meat, cheese, another bun, lettuce, and so on. In the same way, your inherited IRA can be hit by many different taxes, one piled on top of the other. If you’re not careful, these layers of federal, state, and sometimes even local taxes can stack up so much that most of your inheritance is taken away.
Federal income taxes are a major reason why inherited IRAs often shrink more than families expect. When a beneficiary takes money out of an inherited traditional IRA, the money is taxed at the beneficiary’s ordinary income tax rate. That could be as high as 37% if the withdrawal is big enough to push them into the top federal tax bracket.
If Blair withdraws all his inherited IRA money in one year, that amount gets added to Blair’s other income for that year. This can easily put Blair in a much higher tax bracket than usual, leading to a surprisingly large tax bill.
For example, if Blair’s annual income is normally $80,000 and Blair suddenly withdraws $800,000 from an inherited IRA, total taxable income jumps to $880,000, putting Blair into the highest tax brackets. That’s why it’s often wise to spread out withdrawals over several years to try to keep income tax rates as low as possible.
If you reside in a state like California, the math grows more painful. California’s top marginal tax rate of 13.3% applies to all IRA distributions, and there is no state-level deduction for income in respect of a decedent (IRD). This means every dollar withdrawn is fully taxed at the state level—with no offset for Federal Estate Taxes already paid. For those living elsewhere, state tax rules vary; however, all beneficiaries should understand the local landscape to avoid surprises.
If Blair decides to withdraw the entire $800,000 in one year, they will be pushed into the highest federal income tax bracket, at 37%. The federal tax could be $296,000 (37% of $800,000). Now, it’s California’s turn. Another $106,400 could go to the state ($800,000 x 13.3%). After paying the federal and state income taxes ($296,000 + $106,400 = $402,400), Blair would be left with $397,600 out of the original $800,000.
For those paying attention, that’s 37% in federal income tax, plus 13.3% in California state income tax—a total of 50.3% lost to income taxes alone! More than half of the inherited IRA could disappear to tax bills before Blair ever spends a dime.
Even after losing more than half to federal and state income taxes, it’s still not over. There’s also the Federal Estate Tax!
Understanding and planning for each layer of tax is essential to protect your family’s legacy.
Estate Tax: It’s Not Over Yet
The Federal Estate Tax can take 40% of anything in your estate that’s over the exemption amount, which is $13.99 million in 2025. This exemption amount can change if the laws change.
IRAs count as part of your total estate when figuring out this tax, even if no one has taken money out yet.
Let’s say Alex has a $15 million estate, including a $1 million IRA, and passes away in 2025. Because the estate exceeds the federal exemption of $13.99 million by $1.01 million, the extra amount is taxed at 40%. For the $1 million IRA, this means $400,000 could be allocated directly to the federal government as estate tax. That leaves $600,000 for Blair, Alex’s child.
When Blair goes to withdraw the money from the IRA, that means paying federal income tax (which could be up to 37%) and California state income tax (which could be up to 13.3%) on the entire amount he takes out. If Blair withdraws all $600,000 in one year, he could owe about $222,000 in federal income tax (37% of $600,000 is $222,000) and about $79,800 in California state tax (13.3% of $600,000 is $79,800). After paying these taxes, Blair would have only about $298,200 left from the original $1 million IRA. This example illustrates the significant impact that taxes can have on an inheritance if no planning is in place.
For high-net-worth families and even those merely “IRA rich, cash poor,” these layers can leave the next generation with less than they imagined. Sadly, stories like Alex and Blair’s are not rare; without careful analysis, nearly any family with significant retirement accounts risks falling into this expensive trap.
Another Tax Trap: Net Investment Income Tax (NIIT)
The Net Investment Income Tax (NIIT) is an additional 3.8% federal tax that applies to certain types of investment income if your income exceeds a specified level. While IRA withdrawals themselves are not considered “net investment income,” the amount you withdraw from an inherited IRA does count toward your total income for the year.
If your income—including the IRA withdrawal—goes over $200,000 for individuals or $250,000 for married couples filing jointly, you might have to pay the NIIT on your other investment income, like interest, dividends, or capital gains. This means that taking a big IRA withdrawal can trigger this extra tax, adding to the overall tax hit on your inheritance.
While the IRA withdrawal itself isn’t subject to the NIIT, it does mean that any of Blair’s other investment income (like capital gains or dividends) may be taxed an extra 3.8% if the withdrawal from the IRA pushes up the total income past the $200,000 and $250,000 thresholds.
Unpacking the 10-Year Rule: The New Reality for Most Beneficiaries
For decades, beneficiaries of IRAs enjoyed the beloved “stretch IRA” strategy. Rather than taking the entire inherited account at once (and being taxed accordingly), most non-spouses could “stretch” required withdrawals over their lifetimes, paying taxes at levels commensurate with their annual incomes. This strategy smoothed out the tax impact, preserved account value, and allowed the power of compounding to work its magic for years, sometimes decades.
Enter the SECURE Act and its successor, SECURE Act 2.0. The headline change? Most non-spouse beneficiaries now must empty inherited IRAs within ten calendar years of the original owner’s death.
While some exceptions remain for spouses, disabled beneficiaries, certain minors, and individuals less than 10 years younger than the decedent, the vast majority must comply with the “Ten-Year Rule.” The result is a compressed window, during which large withdrawals can push recipients into sky-high tax brackets—obliterating value.
So, how does this happen? How can taxes add up to such a vast amount—sometimes as much as 94.1% of the money in an inherited IRA?
The answer comes down to the way different taxes stack on top of each other when you inherit these accounts. Let’s break down how each tax applies and why waiting until the last year to withdraw everything can lead to such a massive hit.
Five Solutions for Minimizing Taxes: The Professional Approach
Every problem has a solution, and the 94.1% tax trap is no exception. Below are five professional strategies to soften, and in many cases dramatically reduce, the impact of taxes on inherited IRAs—with particular attention to the power and nuance of Roth IRA conversions.
- Bracket-Smart Withdrawals: Make Time Your Ally
Heirs should carefully analyze waiting until the tenth year to withdraw the entire balance of an inherited IRA. Instead, the expert approach is to map out expected income each year and “fill up” lower tax brackets—distributing IRA funds methodically rather than reactively.
Professionals often advise “filling up” lower tax brackets—converting only enough each year to stay within the desired rate (often the 24% bracket). The key is to avoid “bracket creep,” whereby a large one-time conversion pushes you into punitive territory (32%, 35%, 37%).
A Certified Financial Advisor (and, in some cases, CPA can run multi-year simulations to find years when someone’s income is lower due to retirement, a gap year, or other factors. Taking larger withdrawals in these lean years helps avoid being pushed into the highest federal or state brackets.
If your income dips for a year, that’s your window to pull more from the IRA with less tax pain. Conversely, if you wait and combine all income into a high-earning year, you may face unnecessary tax liabilities on the entire amount.
Realistically, strategic withdrawals reduce total taxes, preserve more for the beneficiary, and prevent hidden costs, such as higher Medicare premiums. A considered annual approach is not just wise; it is a staple technique for families serious about building and preserving generational wealth.
- Roth Conversions: The Most Flexible Defense
Roth conversions take center stage for anyone intent on taming the IRS dragon. Here’s how they work: you “convert” all or a portion of your traditional IRA (tax-deferred) into a Roth IRA (after-tax).
With a Roth conversion, you pay taxes now, but everything after grows income-tax-free, and your beneficiaries don’t get hammered when they withdraw. This is especially powerful if you have a large IRA and expect rates to rise, or your heirs are already in high brackets.
The SECURE Act’s rules do apply, but Roth IRA heirs inherit an account that continues to accumulate tax-free growth. When withdrawals are required under the 10-Year Rule, typically, no federal income tax is due.
A well-timed Roth conversion also has knock-on benefits. Because Roth IRAs have no required minimum distributions (RMDs) for account owners, you can leave funds to grow much longer, optimizing the account’s compounding power. Further, Roth conversions can help avoid the 3.8% NIIT because they don’t push income up to the level where NIIT kicks in and can help keep you below the tax’s threshold.
Key Considerations of a Roth Conversion:
- Taxes are due at the time of conversion, so it’s best to have enough cash available to pay without dipping into retirement savings and avoid the under 59½ penalty.
- Conversions are irreversible; once you elect to convert, there’s no turning back.
- Consider deferring conversion or converting only a portion.
- Roth conversions are less attractive if you plan to make substantial charitable gifts—charities pay no tax on inherited traditional IRA dollars.
The takeaway: Roth conversions, when executed with professional coordination, provide future flexibility, mitigate punitive tax spikes for heirs, and deliver peace of mind amid uncertain tax policy shifts.
- Update and Optimize Estate Planning Tools: IRA Legacy Trust
Don’t assume your living trust or will is ready to handle IRAs. I see this mistake all the time.
Many conventional living trusts lack the IRS’s required “see-through” provisions, meaning the trust cannot stretch distributions as an individual beneficiary might. Even if a living trust contains this language, it also has many other provisions that often make it impossible to last beyond five years.
The IRS will often make you take out and pay tax on the whole IRA within five years if your trust isn’t set up right, destroying years of careful savings in the blink of an eye.
A carefully drafted IRA Legacy Trust can help you avoid being compelled to withdraw all the money at once and pay heavy taxes immediately. It allows certain heirs, such as those who are disabled or very ill, to withdraw money over a longer period. It can also protect the inheritance from things like creditors, predators, and divorce.
Using a special IRA inheritance trust—done properly—can help keep your money growing and under control for your family.
It’s also a smart way to ensure your IRA passes on exactly as you want. An IRA inheritance trust offers extra security by making sure specific rules are followed, stretching withdrawals for tax savings, and is designed to shield the money from outside threats.
Setting up this type of trust with help from an experienced attorney can spare your family from unnecessary taxes and complications down the road. Taking this extra step in your estate plan gives everyone greater peace of mind about the future.
- Leverage Beneficiary Designation Rules and Charitable Planning
Tax efficiency is sometimes as simple as choosing the right beneficiary. Under the SECURE Act, “Eligible Designated Beneficiaries” (such as spouses, disabled heirs, minor children, or those within ten years of your age) can stretch the IRA over their lifetimes. When considering other loved ones, weigh who stands to benefit most from inherited IRAs versus other estate assets.
Imagine Maria wants to leave her assets to her two children: Emma, who is 30 and in good health, and Mark, who is 28 and has a long-term disability. Maria has a house and an IRA. With the help of her attorney, Maria decides to leave the IRA to Mark because, under the SECURE Act, a disabled child is considered an “Eligible Designated Beneficiary” and can stretch withdrawals over his lifetime instead of just ten years.
This means Mark can spread out the IRA distributions, paying less tax each year and keeping more money growing tax-deferred for a longer time. Maria then leaves her house to Emma, who would have had to take out the IRA money quickly and pay higher taxes. By planning her estate in this way, Maria helps both her children retain larger shares of their inheritance and reduces the overall tax burden.
If you plan to leave something to charity, it’s almost always best to assign all or part of the IRA directly to that charity. The nonprofit pays zero income tax, and your family keeps more after-tax wealth from other assets.
- Professional Collaboration and Annual Review: An Ongoing Process
The pace of tax law evolution is relentless and piecemeal. That’s why “set it and forget it” solutions often backfire.
It is essential that you annually review beneficiaries, trust language, and withdrawal strategies with both a knowledgeable estate planning attorney and a proactive CPA. Coordination is crucial, particularly when navigating complex rules such as “income in respect of a decedent” (IRD), changes in state residency, or anticipated shifts in income.
Make sure your Certified Financial Planner isn’t asleep at the wheel and that you have a savvy estate planning lawyer watching the interplay between income tax and estate tax planning. This team approach helps each year’s tactics align with your long-term strategy, minimizing taxes and maximizing your family’s outcomes.
Protect Your Legacy with Proactive, Informed Planning
The intricacies of inherited IRA taxation demand attention, expertise, and, above all, action.
It is no longer sufficient to simply name a beneficiary and hope for the best. Times have changed: the SECURE Act’s 10-Year Rule, combined with punitive tax brackets and state-specific pitfalls, means today’s heirs face a very real risk of seeing retirement wealth eroded in less than a decade.
But with the right advice and some good planning, you can take steps to avoid the most significant tax problems.
Start by thinking about Roth conversions if today’s tax rates work in your favor, and consider a strategy to spread IRA withdrawals over several years when possible. Make sure your estate planning documents are up to date and that you’ve carefully chosen your beneficiaries. Review your plan annually and make adjustments if the law or your circumstances change.
A secure financial future isn’t built on autopilot. Reach out to an attorney or financial advisor who specializes in this nuanced area!
If this article resonated with your current situation, don’t wait. Contact our office to schedule a webinar, or request a tailored review. Together, we can work so your hard-earned nest egg delivers the lasting benefit you envision.
Disclaimer: The above content is for general informational purposes only and should not be construed as legal, tax, or financial advice. Individual circumstances require a tailored approach. Consultation with professional advisors is strongly recommende
What We Do
The lawyers and staff at CunninghamLegal help people plan for some of the most difficult times in their lives; then we guide them when those times come.
Our experienced legal team specializes in Estate Planning, Tax Planning, Business Law, and Asset Protection to help protect your wealth and legacy for generations to come. With offices across California, we offer in-person, phone, and Zoom consultations to make expert legal guidance accessible wherever you are.
Many of our clients also find our legal webinars invaluable. We cover a wide range of essential topics, including California-specific issues.
Ready to take the next step? Call us at (866) 988-3956 or schedule an appointment online.
We look forward to working with you.
Warm regards,
Jim
James Cunningham Jr., Esq.
Founder, CunninghamLegal
At CunninghamLegal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.
