Inherited IRA Tax Mistakes: The Costly Errors Beneficiaries Make

Mistakes That Cost Thousands — or More

Inherited retirement accounts come with rules that punish errors with real money. The excise tax on a missed RMD alone is 25% of the amount you should have withdrawn. A botched spousal rollover can trigger immediate taxation on the entire balance. And some mistakes are difficult to correct after a deadline passes.

Here are the errors that come up most often.

Missing the Year-of-Death RMD

If the original account owner had reached their Required Beginning Date and hadn't yet taken their full RMD for the year they died, the beneficiary must complete that distribution by December 31 of the year of death. This catches people off guard because the owner is dead — but the tax obligation transfers to whoever inherits the account.

Miss it, and the 25% excise tax applies to the shortfall. The SECURE 2.0 Act does allow a reduced 10% penalty if you correct the error within two years, but you still have to file Form 5329 and go through the correction process.

Ignoring Annual RMDs Under the 10-Year Rule

Many beneficiaries assume the 10-year rule means they can wait until year 10 to withdraw everything. That's only true if the original owner died before their RBD. If they died after reaching their RBD, annual distributions are required in years 1 through 9 — and the IRS penalty waiver that covered 2021 through 2024 is over.

This is arguably the most common mistake right now, because the IRS took four years to finalize the regulations and gave temporary relief during that period. Beneficiaries who got accustomed to skipping annual distributions are now exposed to the full 25% excise tax.

Non-Spouse Beneficiary Attempting a Rollover

Only surviving spouses can roll an inherited IRA into their own IRA. A non-spouse beneficiary who attempts this — transferring the funds into their personal IRA instead of an inherited IRA — triggers immediate taxation on the entire distribution. The money is treated as a taxable withdrawal followed by an ineligible contribution to the beneficiary's own IRA, creating both an income tax bill and potentially an excess contribution penalty.

The custodian should catch this, but mistakes happen, especially when the beneficiary initiates a transfer without specifying "inherited IRA" as the receiving account type.

Failing to Split Co-Beneficiary Accounts

When multiple beneficiaries inherit the same IRA, ask the custodian promptly about establishing separate inherited IRA accounts and the deadline for separate-account treatment. Without the split, the oldest beneficiary's life expectancy applies to everyone's RMD calculations, forcing larger distributions for the younger beneficiaries.

This is a pure administrative miss — it costs nothing to split the account and there's no downside. But once the deadline passes, the opportunity is gone.

UK Pension: Blowing the Two-Year Designation Window

If a UK pension holder dies before age 75, beneficiaries can receive death benefits free of income tax if the scheme administrator formally designates them within two years after it was notified of the death or should reasonably have known about it. If designation occurs after that window, distributions are taxed at the beneficiary's marginal rate. Tax-free lump sums are also subject to the deceased's remaining Lump Sum and Death Benefit Allowance (LSDBA); amounts above it are taxed at the recipient's marginal rate.

On a £500,000 pension pot, the difference between tax-free and a 40% marginal rate is £200,000. This is not a small oversight.

Naming the Estate as Beneficiary

When a retirement account names the deceased's estate (rather than specific individuals) as beneficiary, the account is treated as having a non-designated beneficiary. This means the 5-year depletion rule applies (if the owner died before their RBD), and the distributions are taxed at compressed estate tax brackets — hitting 37% at roughly $15,000 of income.

Individual beneficiaries named directly on the account would have gotten the 10-year window and their own personal tax rates. This is an estate planning failure, not an administration error, but it's one beneficiaries frequently discover too late.

The Trust Tax Trap

Naming a trust as IRA beneficiary sounds prudent, but unless the trust qualifies as a "see-through" (or "look-through") trust, the distributions are trapped in the trust's compressed tax brackets. The federal trust tax rate hits 37% at roughly $15,000 of income.

Even qualifying see-through trusts face restrictions. A conduit trust passes distributions through to the trust beneficiaries (avoiding the compressed brackets) but can't accumulate funds. An accumulation trust can hold funds but pays the compressed rates on anything not distributed.

The retirement account claims guide flags each of these mistake scenarios with specific corrective steps and, where available, the penalty abatement procedures to reduce the damage.