Do Beneficiaries Pay Tax on Inherited IRA? Understanding the Tax Implications and Strategies for Minimizing Taxes

Your tax liability from any inheritance may be higher than you anticipate as a result of recent modifications to the law regarding inherited IRAs.

Certain heirs may face a significant tax burden due to the new regulations governing inherited IRAs. Over $12 trillion in IRAs were held by Americans as of the first quarter of 2023. You are likely to inherit some of your parents’ money if they were frugal savers throughout their lives.

However, be sure to account for the portion of your inheritance that you will have to give to Uncle Sam before quitting your day job or purchasing a Maserati. Owing to recent legislative modifications and the IRS’s revised interpretation of those modifications, your tax bill may be higher than you anticipate. Traditional IRA beneficiaries have always had to pay taxes on inherited accounts; however, prior to 2020, you could reduce the tax liability by spreading out your withdrawals over the course of your lifetime. You can still use that strategy to spread out withdrawals and taxes over the course of your life if you inherited an IRA before 2020.

However, for the majority of adult children, grandchildren, and other non-spouse heirs who inherit a traditional IRA on or after January 1, 2020, this tax-saving method is no longer available due to the signing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act into law in 2019. These heirs are now left with two choices: either take the money in one lump sum and pay taxes on it all, or move it to an inherited IRA that needs to be completely funded within ten years of the original owner’s passing. (You actually have a little over ten years to empty the account; the clock starts the year after the original owner passes away and ends on December 31 of the tenth year after the owner’s passing.) For instance, in the event that you inherit an IRA in 2020, the account must be closed by December 31, 2030, and the first year is 2021. ).

Inheriting an IRA can be a bittersweet experience. While it represents a financial windfall, it also comes with potential tax implications that beneficiaries need to understand and navigate carefully. This comprehensive guide delves into the tax consequences of inheriting an IRA, explores strategies for minimizing taxes, and provides valuable insights to help beneficiaries make informed decisions.

Understanding the Taxability of Inherited IRAs

The taxability of inherited IRAs depends on the type of IRA inherited:

Traditional IRA:

Distributions are generally taxable at the beneficiary’s ordinary income tax rate. This means that any amount withdrawn from the inherited IRA is added to the beneficiary’s taxable income and taxed accordingly.
Beneficiaries do not have to pay the 10% early withdrawal penalty, even if they withdraw funds before age 59.5. This is a significant advantage compared to traditional IRA withdrawals by the original owner.

Roth IRA:

Withdrawals are generally tax-free if they are considered qualified distributions. This means that the funds have been in the account for at least five years, including the time the original owner of the account was alive.
If the funds haven’t been in the account for five years, withdrawals are taxed as ordinary income.

Strategies for Minimizing Taxes on Inherited IRAs

While there’s no way to completely avoid taxes on inherited IRAs, several strategies can help beneficiaries minimize their tax burden:

1. Stretch Withdrawals Over Time:

For traditional IRAs, beneficiaries can stretch withdrawals over their life expectancy. This allows them to spread out the tax burden over multiple years, potentially reducing their overall tax liability.
For Roth IRAs, beneficiaries can withdraw the funds at any time without penalty, but stretching withdrawals can still be beneficial if they expect to be in a higher tax bracket in the future.

2. Take Advantage of Exceptions:

Beneficiaries who are disabled, chronically ill, or under 18 can treat the inherited IRA as their own. This means they can wait until age 72 (or age 73 if they turn 72 in 2023 or later) to start taking RMDs and paying taxes.
Beneficiaries who are less than 10 years younger than the original owner of the IRA can also treat the IRA as their own.

3. Consider a Roth IRA Conversion:

If the original owner of the traditional IRA converted it to a Roth IRA before their death, the beneficiary would not have to pay taxes on withdrawals. This strategy can be beneficial if the original owner is in a lower tax bracket than the beneficiary.

4. Work with a Financial Advisor:

A financial advisor can help beneficiaries develop a personalized tax-minimization strategy that considers their individual circumstances. They can also provide guidance on managing the inherited IRA and making informed investment decisions.

Additional Considerations for Beneficiaries

1. Required Minimum Distributions (RMDs):

Beneficiaries of traditional IRAs must start taking RMDs by December 31 of the year following the year of the original owner’s death. The amount of the RMD is based on the beneficiary’s life expectancy and the account balance.
Beneficiaries of Roth IRAs do not have to take RMDs unless they are the original owner’s spouse.

2. 10-Year Rule:

Beneficiaries of traditional IRAs who are not the original owner’s spouse must generally deplete the account within 10 years of the original owner’s death. This can be done through annual withdrawals or a lump-sum distribution.

3. State Taxes:

Some states may impose additional taxes on inherited IRAs. Beneficiaries should consult with a tax advisor to determine their state’s specific tax laws.

Inheriting an IRA can be a valuable financial asset, but it’s crucial to understand the potential tax implications. By implementing the strategies outlined above, beneficiaries can minimize their tax burden and make the most of their inheritance. Remember, working with a financial advisor can provide valuable guidance and support throughout the process.

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With one significant exception, the 10-year rule also applies to inherited Roth IRAs: you are exempt from paying taxes on withdrawals and are not required to take required minimum distributions (RMDs) since the original owner was not required to do so. This gives you a lot of flexibility when it comes to withdrawals, but if you can afford to hold off on closing the account until year 10, you will get to benefit from more than ten years of growth that is tax-free.

Initially, tax experts and financial planners believed that non-spouse heirs who inherited a traditional IRA would be in compliance with the law as long as they depleted the account in 10 years. That would provide them with the ability to minimize withdrawals during high-income years and take out more when their income declined — for example, during their retirement years. However, guidance issued by the IRS in February 2022 torpedoed that strategy for some heirs. If your parent died before he or she was required to take minimum distributions, you can withdraw the money at any time, in any amount you choose, as long as the account is depleted in year 10. But under the IRS interpretation of the SECURE Act, if your parent died on or after the date he or she was required to take minimum distributions, you must take RMDs based on your life expectancy in years one through nine and deplete the balance in year 10. Basically, once the original owner has started taking RMDs, you can’t turn them off, says Ed Slott, founder of IRAhelp.com, although the IRS doesn’t require you to withdraw the same amount as your parent would have been required to withdraw.

The IRS eliminated penalties for individuals who failed to take required minimum distributions (RMDs) from inherited IRAs in tax years 2021 and 2022 2 due to ambiguity surrounding the proposed regulations. In July, the relief was extended to the tax year 2023. However, it’s not too early to plan because you might have to begin accepting distributions in 2024. The penalty for failing to make a distribution is 25% of the money that should have been withdrawn. If the missed RMD is made up within two years, the penalty will be reduced to 2010 percent. ).

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do beneficiaries pay tax on ira inheritance

Inherited IRA Rules and Tax Strategy

FAQ

Is an inherited IRA taxable to the beneficiary?

However, distributions from an inherited traditional IRA are taxable. This is referred to as “income in respect of a decedent.” That means if the owner would have paid tax, the income is taxable to the beneficiary. If you inherit the IRA from your spouse, you have the option to treat the IRA as your own.

What if I inherit an inherited IRA?

Once the original beneficiary inherits the IRA, they can name their own beneficiary, called the successor beneficiary. The successor beneficiary then inherits the IRA upon the original beneficiary’s death. It’s essential to remember that each beneficiary must follow specific rules about distributions from the account.

What is the new IRS rule for inherited IRAs?

The 10-year rule requires that all assets in the inherited IRA must be fully withdrawn by the end of the 10th year following the original IRA owner’s death. (If the death occurred in 2019 or earlier, the 10-year rule was a five-year rule.)

What happens if my estate is the beneficiary of an IRA?

When an estate is the default beneficiary of your IRA, it means that the estate will first receive the IRA assets for distributions to heirs of the deceased’s estate. The term “estate” refers to the property you owned at the time of death, and it is a legal entity that is created after you die.

Are inherited IRAs taxable?

An inherited IRA may be taxable, depending on the type. If you inherit a Roth IRA, you’re free of taxes. But with a traditional IRA, any amount you withdraw is subject to ordinary income taxes. For estates subject to the estate tax, inheritors of an IRA will get an income-tax deduction for the estate taxes paid on the account.

What happens if you inherited an IRA?

With inherited IRAs, the type of account and specifics involving the account holder and the beneficiary matter when determining tax liability and strategy. If you’ve inherited an IRA, knowing these details can help you plan for distributions’ tax consequences and choose the best strategy for your situation.

What happens if a primary beneficiary inherited an IRA?

If the executor of the estate asks the IRA primary beneficiary to hand over the IRA back to the estate, that is not a proper action to take. You, as a primary beneficiary, have all the rights to inherit your ancestor’s IRA. If you were to actually cash out the inherited IRA and give it to the estate, you would pay taxes.

Are inherited Roth IRA contributions tax-free?

Withdrawals of contributions from an inherited Roth are tax free. Most withdrawals of earnings from an inherited Roth IRA account are also tax-free. However, withdrawals of earnings may be subject to income tax if the Roth account is less than 5-years old at the time of the withdrawal.