Inherited IRA $20,000 State Tax Exemption for New York Beneficiaries Under Age 59 ½

For individuals who inherit a retirement account in New York state, there is a little-known tax law that allows an owner of an inherited IRA to distribute up to $20,000 from their inherited IRA EACH YEAR without having to pay New York State income tax on those distributions.   While this $20,000 state tax exemption typically only applies to individuals age 59 ½ or older, there is a special rule that allows beneficiaries of retirement accounts to “inherit” the $20,000 tax exemption from the decedent and avoid having to pay state tax on the distributions from their Inherited IRA, even though they themselves are under the age of 59 ½.  

Inherited IRA Owners Under Age 59½

If you inherit a retirement account and you are under the age of 59 ½, there is a whole host of rules that you have to follow in regard to the new 10-Year Distribution Rule, required minimum distributions, and beneficiaries grandfathered in under the old “stretch rules.”  We have a separate article that covers these topics in detail:

GFG Article on Inherited IRA Rules for Non-spouse Beneficiaries    

However, for the purposes of this article, we are just going to focus on the taxation of distributions from inherited IRAs, specifically the tax exemption for residents of New York State.

Universal Tax Rules at the Federal Level

Regardless of what state you live in, there are tax laws at the federal level that apply to all owners of inherited IRA accounts.  The two main rules are:

1. For inherited IRA owners that are under the age of 59 ½, the 10% early withdrawal penalty does not apply to distributions taken from an inherited IRA.

2. All distributions from inherited IRA accounts are subject to taxation at the federal level.

IRA Taxation Rules Vary State by State

While the federal taxation rules are the same for everyone, the state rules for the taxation of inherited IRAs vary from state to state.    In this article, we will be focusing on the inherited IRA tax rules for residents of New York State.

New York State IRA Taxation

New York has a special rule that once an individual reaches age 59 ½ they are allowed to take distributions from pre-tax retirement account sources and not pay NYS Income tax on the first $20,000 each year.  This includes distributions from any type of pre-tax IRA, 401(k), private pension plans, or other types of pre-tax employer-sponsored retirement plans. 

But……..New York has another special rule that allows a beneficiary of a retirement account to INHERIT the decedent’s $20,000 state income tax exemption and use it when they take distributions from the inherited IRA account, even though the beneficiary may be under the age of 59 ½. 

Rule 1:  Decedent Must Have Reached Age 59 ½

For the beneficiary to “inherit” the decedent’s $20,000 NYS IRA tax exemption, the decent must have reached age 59 ½ before they passed away.   If the decedent passed away prior to age 59 ½, the beneficiaries of the retirement account are not eligible to inherit the $20,000 NYS tax exemption.

Rule 2:  The Beneficiary Must Be A Resident of New York

In order to qualify for the $20,000 NYS tax exemption on the distributions from the inherited IRA account, the beneficiary must be a resident of New York State, which makes sense because if the beneficiary was not a resident of New York, they would not be filing a NY tax return.

Rule 3:  The $20,000 NYS Exemption with Multiple Beneficiaries

It’s not uncommon for someone to have more than one beneficiary assigned to their retirement accounts.  For purposes of the allocation of the NYS $20,000 exemption, the $20,000 annual exemption is split evenly between the beneficiaries of their retirement accounts.  For example, if Sue passed away at age 62 and her 2 children Tracy and Mia, both New York Residents, are listed as 50%/50% beneficiaries, once the assets have been moved into the inherited IRAs for Tracy and Mia, they would both be eligible to claim a $10,000 state tax exemption each year for any distributions taken from the Inherited IRA even though Tracy & Mia are both under that age of 59 ½.

Rule 4:  What If One of the Beneficiaries Lives Outside of New York?

But what happens if not all of the beneficiaries are New York residents? Does the beneficiary that lives in New York get to keep the full $20,000 New York State tax exemption?

Answer: No.  In cases where one beneficiary is a NY resident and there are other beneficiaries that live outside of New York State, the $20,000 New York State tax exemption is still split evenly among the number of beneficiaries even though there is no tax benefit for the beneficiaries that are domiciled outside of New York.

Follow Up Question:  Is there any way for the beneficiaries outside of New York to assign their portion of the $20,000 NYS IRA tax exemption to the beneficiary that lives in New York?  Answer: No.

Rule 5:  Multiple Retirement Accounts with Different Beneficiaries

So what happens if Tim is age 35, and is the 100% beneficiary of his father’s Traditional IRA, but his father also had a 401(k) account with Tim and his 3 siblings listed as beneficiaries?  Does Tim get the full $20,000 NYS exemption for distribution from his Inherited IRA that came from the IRA that he was the sole beneficiary of?

Answer: No.  Technically, the $20,000 exemption is split evenly among all of the beneficiaries of the decedent’s retirement accounts in aggregate.  In the example above, since Tim was one of four beneficiaries on his father’s 401(k), he would be allocated $5,000 (25%) of the $20,000 New York State exemption each year.

Rule 6:  How Would You Find Out “IF” There Are Other Beneficiaries?  

There are cases where someone will get notified that they are a beneficiary of a retirement account without knowing who the other beneficiaries are on that account.  Most custodians will not disclose who the other beneficiaries are, they typically just notify you of the share of the retirement account that you are entitled to.  In this case, how do you know how to split up the $20,000 NYS exemption?

Answer: That is an excellent question. I have no idea.

Rule 7:  The $20,000 exemption is an ANNUAL Exemption

The $20,000 NYS tax exemption for distributions from inherited IRAs is an ANNUAL exemption, meaning the owners of the inherited IRAs can use this exemption each year.  For example, Ryan’s father passed away at age 70, Ryan is only age 45, he was the sole beneficiary of his father’s Traditional IRA account, Ryan would be allowed to distribute $20,000 per year for his Inherited IRA account and he would avoid having to pay New York State income tax on those distributions up to $20,000 each year. 

Tax Note: Once the annual distributions exceed $20,000, NYS income tax will apply.

Rule 8: Beneficiary Already Age 59 ½ or Older

If a non-spouse beneficiary is a New York resident and already age 59 ½ or older, do they get to claim both their own $20,000 NYS tax exemption on distributions from their personal pre-tax retirement accounts and then another $20,000 exemption from the inherited accounts?

Answer: No. The $20,000 NYS tax exemption has an aggregate limit for all pre-tax retirement accounts in a given tax year.

Rule 9:  State Pensions PLUS $20,000 NYS Exemption

New York also has the favorable rule that if you are receiving a NYS pension, the amount received from the state pension does not count towards the $20,000 annual IRA tax exemption rule.  For example, you could have someone who retired from NYS at age 55 is receiving a NYS pension for $40,000 per year, and if they inherited an IRA, they may also be able to exclude the first $20,000 distributed from the IRA from NYS income taxation.

Tax Strategies For Non-Spouse Beneficiaries Subject to 10-Year Rule

Now that many non-spouse beneficiaries are subject to the new Secure Act 10-Year Rule, requiring them to deplete the inherited IRA within 10 years, if the decedent was over the age of 59 ½ when they passed, it’s important to proactively plan the distribution schedule to take full advantage of the $20,000 NYS tax exemption otherwise owners of the inherited IRA could end up paying more taxes to New York State that could have been avoided.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

What Happens When A Minor Child Inherits A Retirement Account?

There are special non spouse beneficiary rules that apply to minor children when they inherit retirement accounts.  The individual that is assigned as the custodian of the child, will need to assist them in navigating the distribution strategy and tax strategy surrounding their inherited IRA or 401(k) account.  Not being aware of the rules can lead to IRS tax penalties for failure to take requirement minimum distributions from the account each year.

Minor Child Rule After December 31, 2019

The IRS changed the rules for minor children as beneficiaries of retirement accounts when they passed the Secure Act in 2019.  If the Minor child inherits a retirement account from someone that passes away after December 31, 2019, the minor child is subject to the new non spouse beneficiary rules associated with the new tax law.  The new tax law creates a blend of the old “stretch rule” and the new 10-year rule for children that inherit retirement accounts.  It also matters who the child inherited the account from - a parent, or someone other than a parent. 

Minor Child Inherits Retirement Account From A Parent

If a minor child inherits a retirement account from their parents, and the parent that they inherited the account from passed away after December 31, 2019,  the minor child will need to move the 401(k) or IRA into an Inherited IRA before December 31st of the year after their parent passes away, and then begin taking annual Required minimum distributions (RMDs) from the inherited IRA each year until they reach age 21.   Once reach age 21, they are then subject to the 10-year rule which requires the minor to fully deplete the account within 10 years of turning age 21. 

Age of Majority is 21

Different states have different ages of majority, some 18 and others 21.  But the IRS Released clarifying final regulations in July 2024, stating that for purposes of minor children moving from the annual RMD requirement to the 10-year rule would be the age of 21 regardless of state the child lives in and regardless of whether or not the child is student after age 18. 

Here is an example, Richard passes away in a car accident in March 2024, the sole beneficiary of his 401k at work is his 10-year-old daughter Kelly.  Kelly’s guardian would need to assist her with setting up an inherited IRA before December 31, 2025, and rollover Richard’s 401K balance into that Inherited IRA account.  Since Kelly is under the age of 21, she would be required to take annual required minimum distributions from the account which are calculated base hunter age and an IRS life expectancy table beginning 2025. When she receives those annual RMDs for the Inherited IRA, she has to pay income tax on them, but does not incur a 10% early withdrawal penalty for being under the age of 59 1/2 since they are considered death distributes. 

Kelly will need to continue to take those RMD's each year until she reaches age 21. At age 21, she is then subject to the new 10-year rule associated with non-spouse beneficiaries which requires her to fully deplete that inherited IRA balance within 10 years of reaching the age 21. 

Tax Strategy For Inherited IRAs for Minors

The guardians of the minor child will need to assist them with the tax strategy associated with taking distributions from their inherited IRA account since any money withdrawn from these accounts is considered taxable income to the child.  While the IRS requires the minor child to take a small distribution each year to satisfy the annual RMD requirement, they are allowed to take any amount they would like out of the inherited IRA which creates a tax planning opportunity since most children have very little taxable income, and are in very low tax brackets. 

In some cases, due to the standard deduction awarded to all taxpayers, the child, for example, may be able to take out $12,000 a year, and pay no federal tax on those distributions since they have no income, and the standard deduction covers the full amount of the distribution from the inherited IRA account.  In those cases, it may be prudent for the child to distribute more than just the requested minimum distribution amount each year, otherwise when they are aged 21, they may have income from employment and then these inherited IRA distributions that are required within that 10 year period would be taxable to them at that time at potentially a higher rate.

FAFSA Warning

Another factor to consider one taking distributions from a minor’s inherited IRA is the impact on their college financial aid if they are college bound after high school.  Distributions from these inherited IRA accounts are considered income of the child which is the most punitive category within the college financial aid award formula.  A child’s income, over a specific threshold, counts approximately 50% against any college financial aid that could potentially be awarded.  So, if a child processes a distribution from their inherited IRA for $20,000, while it might be a good tax move, if that child would have qualified for need based college financial aid, they may have just lost $10,000 in aid due to that IRA distribution during a determination year.

When a FAFSA application is completed for a child, the determined year for income purposes of the financial aid award looks back 2 years, so there is a lot of advanced planning by the guardian of the child that needs to take place to make sure larger inherited IRA distributions do not adversely affect the FAFSA award.

Example: If the child will be entering college in the fall of 2025, the FAFSA calculations looks at their income from 2023 to determine how much college financial aid they qualify for.

Traditional IRA vs Roth IRA

It does matter whether the child inherits a Traditional IRA or a Roth IRA. The RMD rule and the 10-year rule are the same, but the taxation of the distributions from the IRA to the child are different.  If the child has an Inherited Traditional IRA, the guardian has to be more careful about making distributions to the minor child because all distributions are considered taxable income.  If the child has an Inherited Roth IRA, by nature of the Roth IRA rules the distributions are not taxable to the minor child. However, Roth IRA's are extremely valuable because all the accumulation within the inherited Roth IRA are tax free upon withdrawal, so typically the strategy is to keep the account intact as long as possible so the child receives as much tax free appreciation as possible at the end of the 10 years.

Minor Child 10-Year Rule

Once the child reaches age 21, the rules change to the 10-year rule which requires the child to deplete any remaining balance in the inherited IRA within 10 years of turning age 21.  The child has full discretion on the amounts that they wish to withdraw from their inherited IRA each year.

Minor Child Inherits A Retirement Account From A Non-Parent

If a minor child inherits a retirement account from someone other than their parents, the inherited IRA rules are different.  The child is no longer allowed to take RMD’s from the inherited IRA each year until age 21, and then switch to the 10 year rule.  If the child inherits a retirement account from someone other than their parent, they are treated the same as any other non-spouse beneficiary, and are immediately subject to the 10 year rule.  They may or may not be required to take RMDs each year IN ADDITION to being required to deplete the account within 10 years, but that depends on what the age of the decedent was when they passed. 

When the decedent passed away, if they had already reached their Required Beginning Date for RMDs, then the minor child would be required to continue to take annual RMD’s from the inherited IRA in addition to the 10-year rule starting immediately. If the decedent has yet to reach the required beginning date for RMDs, then the minor child is just subject to the 10-year rule.

In either situation, a minor child immediately subject to the 10-year rule requires detailed tax planning to avoid adverse and toxic consequences of poor distribution planning to avoid the loss of college financial aid due to the taxable income assigned to the child associated with those distributions from the inherited IRA. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.