Tax rules on individual retirement accounts (IRAs) are different for inherited IRAs. Some differences are positive. For instance, someone who inherits an IRA doesn’t pay a penalty for early withdrawal before age 59 1/2. 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 financial advisor may be a big help in walking you through your options. Try using SmartAsset’s free advisor matching tool to find advisors that serve your area.
A traditional IRA lets you make tax-deductible contributions to your own retirement savings plan. In addition, earnings from investments made with finds 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.
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 1/2 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 to start taking any required minimum distributions (RMDs) and paying any taxes due on them.
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.
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 beneficiary and original owner makes a difference. A Roth IRA inherited from a spouse can be treated as if it were the beneficiary’s own 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.
Inherited IRA Tax Strategies
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 when 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 tax outlay.
Other Strategies to Be Aware of
If you inherited a Roth IRA with funds deposited less than five years ago, one strategy is to simply 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. And a Roth IRA conversion would allow the beneficiary to withdraw the funds later on without incurring income taxes.
A person who inherits an IRA can expose themselves to significant tax consequences if they simply withdraw the money from the account in a single lump sum. By stretching withdrawals out over years, on the other hand, they can keep taxes as low as possible while still benefiting from the inheritance.
Tips on Saving for Retirement
- If you anticipate inheriting or bequeathing an IRA, consider working with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re planning for retirement on your own, it pays to be in the know. SmartAsset has you covered with tons of free online resources to help. For example, check out our free retirement calculator and get started today.
Photo credit: ©iStock.com/Kemal Yildirim, ©iStock.com/bernardbodo, ©iStock.com/PeopleImages