An inherited IRA can carry significant taxes and fees.
Gone are the days of the stretch IRA.
The ability of families to pass their retirement accounts through generations was a beneficial tool for many.
With the passing of the SECURE Act, an inherited IRA has a limited shelf life.
According to a recent Aol.com article titled “How Do I Avoid Paying Taxes on an Inherited IRA?,” the legislation further complicated this type of retirement account.
With an IRA, the original owner incurs a 10% early withdrawal penalty for making withdrawals before age 59½.
Those who inherit an IRA will not be penalized for withdraws.
Although heirs will not be subject to penalties, they may have additional income taxes because of the need to empty the fund in a certain period of time.
More on that below?
Taxes will be calculated according to the tax rate of the beneficiary.
Depending on the size of the account, these withdrawals may push you into a different tax bracket.
The tax situation will look different if the inherited IRA is a traditional IRA or a Roth IRA.
With a traditional IRA, the account is funded with pre-tax dollars.
The investments then grow tax-deferred until withdrawals are made on the funds.
Roth IRAs are funded using after-tax dollars.
These investments grow tax-free and no taxes must be paid on withdrawals as long as withdrawals are qualified distributions.
What are qualified distributions?
For a Roth IRA, the distributions must be made after the assets have been in the account for at least five years.
Can the five years be counted while the original owner was alive?
Yes, it can.
The rules governing inherited IRAs differ depending on the relationship of the beneficiary to the original owner.
If the beneficiary is the surviving spouse, then the IRA can be transferred to the spouse and treated as if it belonged originally to the surviving spouse.
If the heir of the inherited IRA is a child or other family member, then the account must be emptied within 10 years of the date of death of the original owner.
Exceptions do exist for heirs who are chronically ill, disabled, minor children, or 10 years younger than the original owner.
These beneficiaries can also treat the inherited IRA as if it were their own and delay taking Required Minimum Distributions until age 72.
One exception regarding these heirs?
Once a minor child reaches age 18, he or she must then drain the account within 10 years.
It is best to avoid taking a single large sum to drain your IRA.
Instead, you either begin when RMDs are required or use the entire 10 years to spread out your distributions.
If your income is expected to change, you can take larger sums when your income is low and smaller sums when your income is greater.
If you inherited a Roth IRA, you can decrease you tax liability by simply waiting until the funds have been in the inherited IRA account for more than five years.
Those planning to leave an inherited IRA to love ones can minimize the tax liability for their heirs by rolling over a traditional IRA to a Roth IRA while they are still alive.
Doing so allows the heirs to withdraw the funds for use without having these funds subject to income taxes.
This strategy is especially beneficial for those who are in a lower tax bracket than their beneficiaries.
Note: do not convert to a Roth IRA without the advice and counsel of your CPA after running the numbers under all relevant scenarios.
Reference: Aol.com (Feb. 25, 2022) “How Do I Avoid Paying Taxes on an Inherited IRA?”