Inherited retirement assets come with their own set of tax rules. Unfortunately, these have only become more complex since 2019’s SECURE Act came into play.
Beneficiaries who inherit an inherited IRA should typically empty it within 10 years after its owner dies; however, exceptions exist for spouses, minor children, disabled individuals and those less than ten years younger.
Taxes
Losing someone you care for can be heartbreaking, making it especially challenging for beneficiaries to think about the taxation implications of assets they inherit while grieving.
Spousal heirs may opt to keep an account open and adhere to its RMD schedule, or can use either of two withdrawal methods: five- or 10-year withdrawal methods that allow them to distribute funds over a longer period based on their life expectancies instead of those of the deceased.
Beneficiaries have several options when inheriting an IRA or another retirement account, such as a 401(k), 403(b) annuity or state deferred compensation plan, to invest their inherited funds. They could roll them over into an existing IRA or add them to an existing retirement plan such as 401(k), 403(b) annuity or state deferred compensation program; alternatively they could convert some or all of the inherited IRA funds to Roth IRAs which do not subject RMDs; choosing an effective strategy requires careful thought, which many benefit from consulting qualified tax or financial professionals when inheriting retirement accounts of this nature.
Distributions
An Individual Retirement Account, or IRA, is a tax-advantaged investment account designed to store stocks, mutual funds and bonds tax-free until you take a distribution from it – at which point income taxes must be paid on it.
Assuming control of an inherited IRA involves complex withdrawal and tax rules depending on your relationship to its original account owner and whether or not it’s traditional or Roth. If it comes from your spouse, roll it into your retirement account as though it were your own; but if from someone other than them (ie chronic illness/disability/age >10) or from someone not related, withdrawal options are limited and must be completed within 10 years or it becomes subject to tax penalties.
Plan your withdrawals carefully to decrease taxes and stay out of a higher income tax bracket. Consider taking them over 10 years instead.
Rollovers
RMD rules for inherited accounts can be complex and vary based on type and age of original account holder. To ensure you make an informed decision about your options, it’s wise to consult a tax or financial professional.
Nonspouse beneficiaries generally cannot move distributions from an inherited IRA or plan account into their own IRAs or employer retirement plans, such as 401(k)s or 403(b) annuities; there may be exceptions (complex rules may apply), nor commingle assets belonging to multiple people owned by one individual into one IRA account.
Lump sum distributions can be costly from a tax perspective as they impose an immediate income tax bill and can place beneficiaries into higher tax brackets. A better approach may be taking regular withdrawals over a 10-year period to allow assets to continue growing tax-free – particularly important if beneficiaries still owe W2s and have yet to retire.
Conversions
Though inherited IRA rules can be complex, there are ways to reduce taxes associated with them. If the account owner was aged 70 1/2 and didn’t need the money for income purposes, their beneficiary can make a qualified charitable donation from their inherited IRA to reduce balance without incurring income tax liability.
Non-spouse beneficiaries may wish to shift contributions and investment gains from pre-tax to after-tax status if it makes sense, as can beneficiaries with non-spousal relationships who inherit an IRA from its owner who passes away. Otherwise, beneficiaries could opt for lump sum distribution that won’t trigger the 10% early withdrawal penalty fee–although this strategy could push them into higher tax brackets with additional income taxes due. Options depend on who was the original account holder who died as well as when this occurred; please read up more here about IRA inheritance taxes!
