Inherited IRA tax implications: Inherited an IRA? Do these 5 moves now to avoid huge taxes and costly penalties

Learn the important words about IRAs:

1. A Traditional IRA lets people put in pre-tax money, but withdrawals are taxed. If you inherit one, your withdrawals will also be taxed.
2. A Roth IRA is paid with after-tax money, and withdrawals are usually tax-free after 5 years .
3. Beneficiary means the person who inherits the account.
4. RMDs or Required Minimum Distributions are the amount you must take out each year. Missing them can cost you up to 25%.
5. RBD is the year the original owner had to start taking withdrawals, usually from age 73.

The 10-year rule means some beneficiaries must take out all money within 10 years. Traditional IRAs may also need yearly withdrawals if the owner died after the RBD. The life expectancy method allows some beneficiaries to take withdrawals based on their own life expectancy.
Talk to a financial advisor before doing anything. Tim Witham, founder of Balanced Life Planning, said: “The most common issues with inheriting an IRA are related to understanding the rules of how much needs to be withdrawn, when it needs to be withdrawn, and the tax implications.” A good advisor can explain options and make a safe plan, as per the report by Yahoo Finance.

Avoid taking out all the money at once. For a traditional inherited IRA, that would be taxed as income. Rachel Richards, head of tax at Gelt, warned: “Big taxable withdrawals can push you into a higher tax bracket. That could trigger higher taxes and higher Medicare premiums.”

Know what type of beneficiary you are. There are three types:

1. Spousal beneficiary: If you inherited from your spouse, you can move it to your own IRA or keep it separate. You can take withdrawals based on life expectancy or follow the 10-year rule.
2. Eligible designated beneficiary: This includes minors, disabled people, chronically ill, or someone less than 10 years younger than the owner. They can take distributions over their life or follow the 10-year rule.
3. Designated beneficiary: Most adult children or others not in above groups. Adam Tolliver, financial advisor at Artisan Financial Strategies, said: “You must ensure the entire account balance has been withdrawn by the end of the 10th year after the year of the original owner’s death”, as stated by Yahoo Finance.

Do not forget the power of tax-deferred growth. You can withdraw money immediately, but that may cost you a lot in taxes and you lose the chance for the money to grow tax-free. Example: If you inherit $100,000 in a Roth IRA and leave it invested at 7% per year, it could grow to about $195,000 in 10 years. If you put it in a taxable account instead, you could have about $25,000 less after taxes.
Always name beneficiaries for your inherited IRA. Vincent Birardi, wealth advisor at Halbert Hargrove, said: “Those beneficiaries can take over your inherited IRA upon your passing. This applies even if you inherited an IRA from a non-spouse, and you pass away before the 10-year full liquidation period”, as stated in the report by Yahoo Finance. Contact your IRA custodian to name your beneficiaries and make sure the process is done correctly. Managing an inherited IRA is hard, but learning the rules, talking to an advisor, following withdrawal rules, letting the money grow, and naming beneficiaries can save you a lot of taxes and stress during a tough time.

FAQs

Q1. What is the 10-year rule for inherited IRAs?

The 10-year rule means you must withdraw all money from an inherited IRA within 10 years of the original owner’s death.

Q2. Do I have to pay taxes on an inherited IRA?

Yes, withdrawals from a traditional inherited IRA are taxable, while Roth IRA withdrawals are usually tax-free if the account is over five years old.