Inheriting an Individual Retirement Account (IRA) can be both a blessing and a burden, especially when it comes to navigating tax implications. Grasping the intricacies of these accounts is crucial for making wise decisions regarding distributions and taxes.
If you’ve recently inherited an IRA, the excitement of newfound assets might be overshadowed by confusion regarding how to handle withdrawals and their potential tax consequences.
Whether you just want to learn about inherited IRAs or are looking to maximize your benefits while adhering to IRS regulations, this guide will tell you everything you need to know about taxes on inherited IRAs.
1. Traditional vs. Roth IRA Taxes
The tax rules depend entirely on the type of account you inherit. Distributions from an inherited Traditional IRA are ordinary income and are subject to federal and state income taxes. In contrast, qualified distributions from an inherited Roth IRA are tax-free, provided the account has met the five-year holding requirement.
2. The 10-Year Withdrawal Rule
The SECURE Act mandates that most non-spouse beneficiaries must follow the 10-year rule. This means that the full account balance must be withdrawn and remitted by December 31 of the 10th year after the original owner’s death.
When these payouts are not managed effectively, you may experience an unexpected increase in marginal tax rates. Seek out professional guidance on the best way to reduce taxes on inherited IRA account distributions if you would like help structuring these payments.
3. Required Minimum Distributions (RMDs)
Depending on your relationship to the deceased and whether they had already started taking RMDs, you may be required to take annual withdrawals during years one through nine of the 10-year window.
Failure to take a required RMD may result in a significant IRS penalty (up to 25% of the amount that should have been taken).
4. Special Rules for Spouses
Surviving spouses have unique advantages. A spouse can generally transfer an inherited IRA straight into their own individual IRA.
This allows them to avoid the strict 10-year rule, continue making contributions, and delay taking RMDs until they reach their own required beginning date.
5. No Early Withdrawal Penalty
In general, if you take cash out of your retirement account before age 59, you may be liable for a 10% early withdrawal penalty.
The key difference, however, is that inherited IRA distributions are totally exempt from the 10 percent early withdrawal penalty, making it easier to access the funds if needed.
6. Stepped-Up Basis Exemptions
Physical assets and stocks receive a “stepped up” basis to reduce the capital gains taxes when they are inherited, but IRAs don’t.
Beneficiaries are subject to standard income tax rates. Distributions are often best scheduled in even amounts or in years when your total taxable income is below the average to keep your overall tax rate from climbing.
Knowing all that will keep you on the right track when navigating taxes on an inherited IRA you own before taking distributions. If you still need information regarding what beneficiaries should be aware of, Creative Planning has a well-crafted, relevant guide.
