The standard tax rules on individual retirement accounts (IRAs) change when dealing with inherited IRAs. Some differences are positive. For instance, someone who inherits an IRA doesn’t pay a penalty for early withdrawal before age 59.5. On the negative side, special rules for inherited IRAs may force beneficiaries to take the money out sooner than they’d like. That can trigger an unwanted income tax obligation and even increase taxes on other income by pushing the beneficiary into a higher tax bracket. Fortunately, there are ways to avoid or reduce the potential tax bite on an inherited IRA. A tax lawyer may be able to help walk you through your options.
What Is an IRA?
A traditional IRA lets you make tax-deductible contributions to your own retirement savings plan. In addition, earnings from investments made with funds in an IRA grow tax-free. You don’t pay taxes on either contributions or earnings until you start making withdrawals later on after retiring.
A Roth IRA is a retirement savings vehicle that you fund with after-tax dollars. Roth IRA contributions don’t get you a tax deduction. But earnings on funds in a Roth IRA also grow tax-free and, unlike a traditional IRA, you don’t owe income taxes on Roth withdrawals once you start taking money out in retirement.
Cashing Out an Inherited IRA
An inherited IRA, also known as a beneficiary IRA, is either a traditional or Roth IRA that has been left to you by someone who has deceased. For most individuals, you can cash out an inherited IRA or withdraw at any time. You generally have 10 years from the death of the original owner to cash out all of the assets within the inherited IRA.
However, there may be some tax consequences of cashing out an inherited IRA that you’ll want to plan for before you start making withdrawals. Depending on whether you are inheriting a traditional or Roth IRA, the tax consequences could be very different.
Tax Consequences of Inheriting a Traditional IRA
The main thing to remember about inheriting a traditional IRA is that distributions are generally taxable at the beneficiary’s ordinary tax rate. If you inherit an IRA and take money out of it, you’ll pay income taxes on it. If the
withdrawal is big enough to lift your income into a higher bracket, you may owe more taxes on the rest of your income, as well.
Inherited IRAs do qualify for some special treatment, however. For instance, while withdrawals taken by the original account owner before age 59.5 are ordinarily subject to a 10% penalty, a beneficiary doesn’t have to pay that penalty even when withdrawing at a younger age.
Beyond that, much depends on just who bequeathed you the IRA. If the original owner was your spouse, you can simply take ownership of the IRA. Then, just as if you were the original owner, you can wait until age 72 (or age 73 if you turn 72 in 2023 or later) to start taking any required minimum distributions (RMDs) and paying any taxes due on them.
Tax Consequences of Inheriting a Roth IRA
Funds withdrawn from an inherited Roth IRA are generally tax-free if they are considered qualified distributions. That means the funds have been in the account for at least five years, including the time the original owner of the account was alive. If they don’t meet the qualified distribution criteria, funds withdrawn from an inherited Roth IRA are taxed as ordinary income.
Once again, the relationship between the beneficiary and the original owner makes a difference. A Roth IRA inherited from a spouse can be treated as the beneficiary’s account. This means the new owner can take tax-free withdrawals at his or her option.
If the Roth IRA came from anyone else, however, the beneficiary has to take RMDs just as if it were a traditional IRA. That means withdrawing the full amount within 10 years. Also, the same exceptions for disabled, chronically ill, and underage beneficiaries apply.
Tax Planning Strategies for Inherited IRAs
One inherited IRA tax management tip is to avoid immediately withdrawing a single lump sum from the IRA. Instead, wait until RMDs are due or, if you got the IRA from a non-spouse, stretch withdrawals over 10 years.
RMDs are taxable and can change your tax bracket and increase your overall tax burden. But if, as is often the case, you are in a lower tax bracket when you have to start taking them, you may be able to save on taxes by deferring withdrawals until the RMD rules force you to start.
If you have to empty the account in 10 years, you don’t have to withdraw equal annual amounts. You can instead wait until your income is lower than normal, then take a larger withdrawal from the inherited IRA. Similarly, if your income is higher in another year, you can take less that year, as long as the entire amount is withdrawn after 10 years. This income-leveling strategy can result in a lower overall
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If you inherited a Roth IRA with funds deposited less than five years ago, one strategy is to wait before taking those funds out. When the five-year period has elapsed, withdrawals will be treated as tax-free qualified distributions.
One of the most effective tax-management strategies has to be undertaken by the original owner before he or she dies. With this approach, the owner converts a traditional IRA to a Roth IRA, paying any taxes due on contributions and earnings.
This can reduce the overall taxes paid on the funds if the original owner is in a lower tax bracket than the intended beneficiaries. A Roth IRA conversion would allow the beneficiary to withdraw the funds later on without incurring income taxes.
Inherited IRAs: Exceptions to the Rule
If you inherited the IRA from someone other than a spouse, you can’t wait for RMDs to start. Instead, you have just 10 years from the time you inherited the account to withdraw and pay taxes on the entire amount. Exceptions apply if you are disabled, chronically ill, or an underaged child. Another exception applies if you are less than 10 years younger than the original owner of the IRA.
In all these cases, you can still treat the IRA as your own and wait until RMDs start at age 72 (or age 73 if you turn 72 in 2023 or later). The right choice for you is going to depend on a number of financial factors that might best be approached with a professional advisor.
Conclusion
Navigating the tax implications of an inherited IRA can be complex and overwhelming. However, by understanding the rules and leveraging strategic withdrawal plans, you can minimize the tax burden and maximize the benefits of your inheritance. Consulting with a tax lawyer can provide personalized guidance and ensure you make the most informed decisions. Whether it’s determining the best time to take distributions, converting accounts to Roth IRAs, or utilizing income-leveling strategies, professional advice can be invaluable. Take the time to explore your
options and plan accordingly to secure your financial future.