Inherited IRA Mistakes That Trigger Large Tax Bills

Inherited IRA mistakes that trigger large tax bills come from rules that changed in 2020 and beneficiaries who never learned them. Missed RMDs, a 10-year clock ignored, a botched transfer, an inherited IRA wrong withdrawal in a high-income year, or a wrong spousal election can each turn a six-figure inheritance into a punishing tax bill.

Why These Mistakes Cost so Much

An inherited IRA is a tax-deferred asset, not an heirloom. Every dollar inside was contributed pre-tax (or grew tax-free in a Roth) under specific rules. When the original owner dies, those rules transfer to the beneficiary along with the balance. Many heirs do not read them. The custodian sends paperwork. The beneficiary signs it. Years later, a tax preparer or the IRS notices something was wrong, and the inherited IRA tax surprise arrives with penalty and interest already attached. Each inherited IRA tax consequence on this list is preventable, but only if the beneficiary or their advisor identifies it within the first few months after the inheritance.

The damage compounds for three reasons. First, inherited IRA distributions are ordinary income, taxed at the heir’s marginal rate. An heir already earning $200,000 may push another $300,000 of inherited IRA assets into the top federal bracket plus state tax. Second, the rules changed in 2020 under the SECURE Act, then changed again under SECURE 2.0 in 2022, and final regulations only landed in 2024. Many CPAs and custodians have not fully caught up. Third, an inherited IRA penalty for getting the timing or paperwork wrong is severe, and the available fixes are limited. The result is an inherited IRA tax bill that often arrives years after the underlying mistake, with interest already accrued.

Mistake One: Cashing Out the Entire Account as a Lump Sum

The most expensive mistake is also the most common. A beneficiary inherits a $600,000 IRA, calls the custodian, asks for a lump sum check, and deposits the proceeds in a savings account. The full $600,000 becomes taxable income in that year. A married couple already earning $250,000 may see federal tax alone exceed $200,000 on the inherited money once the distribution stacks on top of wages. State tax adds more. Roughly one-third to nearly half of the inheritance can vanish in a single year. This is the most costly inherited IRA mistake on the list because the result is locked in the moment the check clears.

The proper move is a trustee-to-trustee transfer into a properly titled inherited IRA in the beneficiary’s name. The account stays tax-deferred and continues to grow under the rules that applied to the original account owner. Distributions can be spread across the available window. Nothing is forced into a single tax year unless the heir chooses it. The transfer must be requested correctly. If a check is made payable to the beneficiary instead of to the receiving custodian, the IRS may treat the entire balance as a full distribution even when the beneficiary intended to redeposit it. The correct approach is to direct the funds custodian-to-custodian, with titling that identifies both the deceased account holder and the beneficiary. This kind of inherited IRA error is unforgiving: non-spouse beneficiaries do not get the 60-day rollover relief that applies to other IRAs, and the wrong distribution cannot be undone.

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Mistake Two: Missing Annual RMDs Inside the 10-year Window

For deaths after 2019, most non-spouse beneficiaries fall under the 10-year rule. The account must be emptied by December 31 of the tenth year following the year of death. Many beneficiaries assume this means no withdrawals are required until year 10. That is not always the case, and an inherited IRA RMD mistake here compounds across multiple tax years.

Final regulations issued in 2024 confirmed that if the original owner had already passed their required beginning date and started taking required minimum distributions before death, most non-spouse beneficiaries subject to the 10-year rule must also take annual RMDs in years one through nine, with the full balance distributed by year 10. The first RMD a beneficiary owes is calculated using their own life expectancy under the IRS Single Life Table, which sets the schedule for the years that follow. The IRS waived the penalty for missed RMDs in 2021, 2022, 2023, and 2024 while the rules were finalized, but that grace period is gone. Beginning in 2025, the missed RMD penalty under SECURE 2.0 is 25% of the shortfall, reduced to 10% if corrected within a defined window. A beneficiary who was supposed to take a $40,000 RMD and took nothing may owe a $10,000 penalty plus the income tax on the corrected distribution. This category of inherited IRA distribution mistake often surfaces only when a tax preparer reviews multiple years at once and reads the current RMD rules against returns that were filed under the old assumptions.

Mistake Three: Surviving Spouses Making the Wrong Election

A surviving spouse has more options than any other designated beneficiary. The wrong choice can cost as much as any other mistake on this list. Three primary paths exist: treat the IRA as your own (rolling it into a personal IRA), keep it as an inherited IRA in your name as the surviving spouse, or take a delayed assumption later.

Each path has different consequences. A surviving spouse under age 59½ who treats the IRA as their own loses the ability to withdraw without the 10% early withdrawal penalty. Keeping it as an inherited IRA preserves penalty-free access at any age but may force RMDs sooner than necessary. The right answer depends on the surviving spouse’s age, income needs, and whether they have other liquid assets. The same election analysis applies to an inherited Roth IRA, with the added consideration that Roth distributions are generally tax-free if the five-year rule has been satisfied, which changes the math on whether to treat the account as the spouse’s own. Many spouses default to whatever the custodian’s form suggests, and the custodian’s form does not know any of those variables.

Mistake Four: Stacking Distributions in a High-Income Year

The 10-year rule gives a window. The window is meant to be used. A beneficiary who waits until year 10 and pulls the entire balance in one year may convert what could have been a manageable income increase across nine years into a single inherited IRA large tax bill at the highest marginal rate.

The opposite mistake is also common: a beneficiary who pulls large distributions during peak earning years stacks those dollars into a higher tax bracket, when waiting one or two years until retirement would have placed the same amount in a much lower one. Both errors come from treating the inherited IRA as a separate problem instead of integrating it with the heir’s broader tax picture. This is the inherited IRA tax trap that catches sophisticated earners most often: the rules technically allow the distribution, but the timing turns a flexible window into a punishing one. A tax-aware distribution plan looks at projected income, planned retirement date, anticipated Roth conversion windows, and known life events that may shift brackets up or down. The plan tends to spread distributions across years when income is low and minimize them in years when it is high.

Mistake Five: Missing the 10-year Deadline Entirely

For most non-spouse beneficiaries who inherited after 2019, the account must be empty by the end of the 10th year following the year of the original account owner’s death, with December 31 as the hard cutoff. Any balance remaining after that deadline triggers the missed RMD penalty on the entire remaining amount. A beneficiary who inherited in 2020, never withdrew anything, and shows up in 2031 with $700,000 still in the account may owe a 25% penalty (potentially reduced to 10% with timely correction) plus full ordinary income tax on the distribution that should have happened. The longer the tax deferral runs unmanaged, the larger the eventual taxable distribution.

The deadline is not negotiable and not extended for life events, market conditions, or beneficiary hardship. The penalty applies to the shortfall, not to the original account value. Calendaring the deadline at the moment of inheritance is the simplest defense, and pairing the calendar reminder with an annual review of the distribution plan turns a one-time deadline into a structured nine-year process.

Mistake Six: A Botched Custodian-to-Custodian Transfer

Beneficiaries often want to move an inherited IRA to a different custodian. The desire is reasonable. The execution is where mistakes happen. The transfer must move directly from one custodian to another with the correct titling, typically formatted as the deceased’s name “deceased” followed by “inherited IRA for the benefit of [beneficiary’s name].”

If the receiving custodian opens the account with incorrect titling, or if the funds are sent to the beneficiary as a check made payable to them personally, the IRS may treat the transaction as a full distribution. Non-spouse beneficiaries cannot redeposit those funds. The 60-day rollover does not apply. Once distributed, the tax bill is locked in. An inherited IRA rules violation at the transfer stage is one of the few that custodians can prevent on their end, but only if the request is worded correctly. Confirming the titling in writing before initiating the transfer, and verifying that funds will move custodian-to-custodian without passing through the beneficiary, prevents this error.

Mistake Seven: Ignoring the Roth Conversion Window

An inherited traditional IRA cannot be converted to a Roth by the beneficiary. That door is closed. But the inherited IRA’s distribution schedule interacts with the beneficiary’s own retirement accounts, and the tax bracket created by inherited IRA withdrawals may shut down opportunities the beneficiary did not realize they had.

A beneficiary in their early 60s who inherits a large IRA may need to take meaningful distributions during what would otherwise have been their best years for converting their own pre-tax retirement savings to a Roth. Inherited IRA distributions stack on income, push the marginal bracket up, and may render Roth conversions on the beneficiary’s own accounts uneconomic for the duration of the 10-year window. A coordinated plan considers both accounts together. Inherited IRA distributions are scheduled in years when the beneficiary’s own Roth conversion needs are lower; conversions on the beneficiary’s own accounts happen in years when inherited IRA distributions are smaller. The same 10 years can either compound the tax problem or solve it, depending on whether the two accounts are planned together or separately.

Mistake Eight: Assuming the Custodian or CPA Will Catch Errors

Custodians administer accounts. They do not optimize them. Many CPAs are excellent at filing what is in front of them but were not trained on the SECURE Act regulations. Some tax preparers still apply pre-2020 rules to post-2020 inheritances, producing an inherited IRA tax error that goes undetected for years. Inherited IRA decisions sit at an intersection of estate, tax, and investment planning that few professionals own end-to-end. By the time an inherited IRA wrong distribution appears on a return, the corrective options are usually limited to penalty mitigation, not avoidance.

Holland Capital Management’s investment philosophy, Preserve. Strengthen. Grow.™, applies directly to inherited assets. The first job is preservation, which on an inherited IRA means making no irreversible mistakes in the first six months. The second is strengthening, which means using the 10-year window to optimize tax outcomes and integrate the account with the beneficiary’s broader plan. The third, growth, follows naturally when the first two are done correctly. The mistakes on this list damage all three, often in the first 30 days, often before anyone realizes a decision was even being made.

What Changed in 2020 and Again in 2022

The SECURE Act took effect January 1, 2020. For most non-spouse beneficiaries inheriting after that date, the stretch IRA was eliminated and replaced with a 10-year deadline. The lifetime stretch that allowed beneficiaries to spread distributions across their own life expectancy is gone for this group, and the tax consequences of that change are still working through inherited accounts that were set up under the old assumptions. SECURE 2.0, signed at the end of 2022, refined several rules and reduced the missed RMD penalty from 50% to 25%, with a further reduction to 10% for timely correction. Final IRS regulations in 2024 confirmed that beneficiaries subject to the 10-year rule must also take annual RMDs in years one through nine if the original owner had already begun RMDs.

For inheritances that occurred before 2020, the old stretch rules continue to apply. Eligible designated beneficiaries (surviving spouses, minor children of the deceased, disabled or chronically ill heirs, and beneficiaries not more than 10 years younger than the deceased) follow different rules entirely. Determining which rule set applies is the first analytical step on any inherited IRA. Applying the wrong rule set is itself a mistake, and the most expensive inherited IRA mistake examples on a return often trace back to this single misclassification: a 2018 inheritance treated under post-SECURE Act rules, or a post-2020 inheritance still being stretched as if the old rules applied. The fact pattern that matters is the original owner’s date of death, the beneficiary’s relationship and age, and whether the original owner had begun taking RMDs. An inherited IRA filing error at this stage compounds across every subsequent year.

How to Think About the Next Decision

An inherited IRA decision tends to look simple in the moment and complicated in retrospect. The custodian’s paperwork presents three choices. The beneficiary picks one. Years later, the consequences become clear. The way to avoid the mistakes on this list is to slow down at the front of the process. Confirm which rule set applies. Calculate the projected tax cost of each available path. Coordinate the inherited IRA distribution schedule with the beneficiary’s own income trajectory, retirement timeline, and other tax planning. Get the titling right on day one. Calendar the deadlines. Review the plan annually as income, tax law, and life circumstances change.

The cost of the mistakes on this list is measured in tens or hundreds of thousands of dollars. The cost of getting the decisions right is a few hours of analysis up front and a structured review process across the 10-year window. Heirs who treat the inheritance as a planning event rather than a paperwork event tend to keep meaningfully more of what was left to them. For a fuller view of how this fits with broader inheritance decisions, the inherited IRA strategy guide walks through the full decision framework, and the inheritance and sudden wealth planning resource addresses the broader picture when an IRA is one piece of a larger inheritance. Tax-aware distribution timing connects directly to tax-efficient investing, and beneficiaries planning their own retirement alongside an inherited account should also consider how Roth conversion strategy interacts with the 10-year window. Heirs already navigating the broader transition often find the inheritance financial planning resource a useful companion piece, and the receiving an inheritance guide addresses the first 90 days specifically.