Beneficiaries of an inherited IRA must make some difficult choices. After 2019’s SECURE Act upended some long-standing practices, it may be worthwhile consulting with an independent fiduciary financial professional before making decisions on your own.
An instant withdrawal could put you into a higher tax bracket and may mean forgoing potential tax-deferred growth opportunities. Instead, follow these strategies:
Don’t Take a Lump Sum
Beneficiaries of an Individual Retirement Account (IRA) face various rules and options depending on their relationship to the deceased owner, age and account type (traditional vs. Roth). While the IRS provides comprehensive regulations regarding IRAs, it’s wise to consult a financial or investment professional who can give insight into all available choices.
Inherited IRAs must be depleted within 10 years, but taking large withdrawals all at once could push beneficiaries into higher tax brackets. Instead, taking smaller withdrawals throughout the year may make more sense and considering converting some assets to Roth IRAs can reduce overall taxes burdens.
Don’t Cash Out
Cashing out an IRA early may seem tempting as a quick and easy way to access money quickly; however, doing so comes with significant drawbacks. Non-spouse beneficiaries must withdraw all inherited account balances within 10 years after original account holders pass away or face paying income taxes on withdrawals made within that timeframe.
As distributions from traditional inherited IRAs can have a substantial tax impact, it’s wise to limit how much is taken out during your 10-year window. As they’re considered ordinary income and will be taxed accordingly.
Financial advisors can provide invaluable assistance when it comes to understanding your options and developing an effective plan for handling an inheritance, which might include taking smaller withdrawals over several years to reduce tax impact. It is recommended for all IRA beneficiaries to consult an adviser knowledgeable in this area of law.
Convert Some Funds to a Roth
If you inherit a traditional IRA and wait to withdraw anything until year 10, your tax bill could skyrocket due to distributions being taxed as ordinary income and an unexpectedly large withdrawal causing you to fall into higher tax brackets.
An effective alternative would be to roll over an IRA into another account and take required minimum distributions over your or their life expectancies, or those of their decedent. This allows funds to continue growing tax-deferred, which could save substantial sums of tax.
Roth conversion should only be considered if your tax rate in retirement will be lower than it is now. Doing so may incur upfront taxes but could save on withdrawal taxes down the line when your tax rate rises; an accountant can assist with running these numbers for you. Regardless of which strategy is taken, RMDs should begin being taken at least every five years following an account holder’s death.
Know the Deadlines
The IRS has very specific rules regarding distributions from IRAs. Any funds acquired through inheritance must be distributed according to these guidelines or they could face penalties from the IRS, so it’s wise to consult a financial professional prior to making decisions about how best to utilize an inheritance account.
Joint beneficiaries have until September 30 of the year following an original owner’s death to separate their IRA assets as RMDs will be calculated based on each beneficiary’s single life expectancy factor beginning the following year. Beneficiaries who fail to meet this requirement face a 50% excise tax penalty on any remaining balance in their account.
Earmarking accounts properly requires knowing if an inheritance falls under the 10-year rule, since nonhuman beneficiaries (like trusts and charities) don’t have life expectancies that factor into their calculations and must instead adhere to a five-year rule which means their IRA needs to be depleted within that time. This might not always be ideal.
