How to Avoid Paying Taxes on an Inherited IRA
An IRA allows assets to grow tax-deferred for decades. When its owner passes away, beneficiaries are obligated to take required minimum distributions (RMDs) and pay taxes on them; depending on their relationship to the deceased they have various options available to them when taking these RMDs.
Each option comes with its own set of rules and deadlines to abide by, here are some strategies to avoid paying taxes on an inherited IRA:
Disclaim the Inherited IRA
If you inherit an IRA, it is crucial that you understand all your options and deadlines for managing it properly. Your decision may have significant tax repercussions depending on how it is managed.
Assume your mother has named you as primary beneficiary for her $4 million brokerage account and her $2 million IRA, each worth $5.43 million or more when she passes. Her estate would owe federal estate tax, while her IRA qualifies as a nontaxable gift and so avoids this liability.
Beneficiaries can disclaim an IRA in full or part by sending a letter directly to its custodian within nine months of death, clearly stating they refuse to accept this property as inheritance.
Lily cannot simply choose not to take distributions from her IRA or do nothing with it, since that would render her disclaimer ineffective. Furthermore, she must verify that she has not accepted possession by paying bills out of it or altering investments within it.
Transfer the Inherited IRA to Yourself
IRAs are tax-advantaged retirement accounts that allow people to save for the future tax-free. When account holders pass away, their heirs must pay taxes on withdrawals made from IRAs; fortunately there are various strategies they can utilize in order to minimize their tax bill.
The rules surrounding an inherited IRA can be complex. They depend on several factors, including who the deceased IRA owner was and whether required minimum distributions (RMDs) have begun being taken.
One way to reduce your tax liability is to roll an inherited IRA into your own IRA or employer retirement plan (such as 401(k) or 403(b). Once invested, withdraws will be subject to income taxes; taking a lump-sum distribution may increase taxable income significantly and increase the taxes that must be paid.
Transfer the Inherited IRA to an Alternate Beneficiary
Tax laws surrounding IRAs are complex, making it easy to overlook hidden tax traps. For instance, inheritors who do not inherit an IRA from their spouse must roll it over into another IRA within 10 years or else income taxes could levy up to half its value as income taxes alone.
In certain instances, the original owner of an IRA may have been required to take required minimum distributions (RMDs), in which case all funds in their IRA must be dispersed within 10 years in order to meet tax liabilities associated with higher tax brackets. Such withdrawals could potentially incur massive tax bills for beneficiaries who inherited it as the withdrawal could trigger higher bracket taxes and cause them to pay an even greater percentage tax bill on withdrawal than expected.
If the original owner of an IRA is still living, they can utilize various strategies to reduce taxes for his or her beneficiaries. One such strategy would be converting to a Roth IRA while living; doing this may reduce total amount paid in taxes.
Convert the Inherited IRA to a Roth
As you grieve the passing of a loved one, taxes may not be at the forefront of your mind; however, taking steps to maximize inheritance while mitigating taxes is still possible. For beneficiaries with an IRA they have various options available to them such as rolling over assets into an IRA in their name or even switching it out for a Roth IRA account.
Non-spousal heirs must withdraw all their traditional IRA assets within 10 years and begin taking required minimum distributions (RMDs) immediately, while spouseal heirs can spread withdrawals out over their life expectancy.
Beneficiaries may opt to stagger withdrawals from an inherited IRA by opening an inherited account and requesting trustee-to-trustee transfers between accounts, thus lowering taxes paid over their lifetimes by spreading out withdrawals over multiple decades. The value of this strategy for you will depend on both you and your heirs’ circumstances.
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