How to Avoid Paying Taxes on an Inherited IRA
An individual retirement account (IRA) inherited by you can provide a significant windfall, but how it’s treated by tax authorities will vary based on a variety of factors. Learn your options for managing it effectively to maximize benefits while minimizing taxes.
Nonspouse beneficiaries must empty their IRA accounts within 10 years, but can choose among various withdrawal methods. Here are some strategies they might want to consider:
Take a lump-sum distribution.
Rules surrounding inherited or beneficiary IRAs can be complex. Their tax treatment depends on a number of factors including type, beneficiary and withdrawal method.
Spouses may opt to become the owner of their IRA by converting it to their own, deferring required minimum distributions until age 73 and deferring required minimum distributions until then. But this strategy could prove costly if their deceased partner had lower tax rates than them.
Non-spouse beneficiaries have two options for taking distributions from an inherited IRA: either taking it in one lump sum payment, or setting aside annual RMDs to be taken throughout their lives. The latter approach may be advantageous as it helps avoid an abrupt spike in taxable income that could push them into higher tax brackets.
Non-spouse beneficiaries who wish to open stretch IRAs must do so no later than December 31 of the fifth year following the decedent’s death, otherwise there will be a 10% penalty applied.
Donate to charity.
Inherited IRAs can be an enormous boon, yet they also present some tax obligations. Withdrawals from non-Roth accounts must be reported and taxed in the year of withdrawal, unlike withdrawals from Roth accounts which will only incur taxes after distribution.
Non-spouse beneficiaries who inherit traditional IRAs must deplete them within 10 years or face penalty charges; RMDs cannot be spread out over their lifetimes as previously intended, according to Ed Slott, an individual retirement account specialist and certified public accountant. He notes this new rule effectively “hammers” their yearly tax liability.
One way to reduce this tax load is by donating the inherited funds to charity. Donating won’t reduce RMDs, but will lessen the sting when withdrawing it in full later on. Donations made from your inherited IRA may be made via trustee-to-trustee transfer with your financial institution holding your account, with beneficiaries reporting it as income on their taxes returns – with charitable deductions typically exceeding any additional taxes due.
Spread out distributions over time.
IRA withdrawal rules can be complex, depending on factors like account type, beneficiary and date of death of original account holder. To stay compliant with IRS regulations and avoid breaking them inadvertently, beneficiaries should seek advice from a tax professional when making decisions about withdrawing assets from an IRA.
As an example, it may make more financial sense for nonspouse beneficiaries of an inherited IRA to take distributions during lower-income years rather than waiting until age 70 – this may help minimize tax bills overall.
As part of an inheritance plan, it’s also crucial to take current and future federal income tax brackets into account. For instance, if one family member falls within the 22% bracket while his heirs all fall into the 12% one, dividing up inheritance equally between each account instead of taking bigger distributions to reduce tax rates at higher rates. Of course, this strategy may not always be practical or feasible so it’s wise to consult a tax professional first on any strategy used.
Disclaim the inheritance.
Naming children as beneficiaries on an IRA may seem generous, but doing so may result in more of their inheritance being taxed than planned by the IRS. Distributions from traditional IRAs inherited as gifts are taxed according to each beneficiary’s current income tax bracket – so children in higher brackets could end up paying more taxes than expected.
If you inherit an IRA, consult with a tax or retirement professional before taking any actions. IRS rules vary depending on the type of IRA and whether or not the beneficiary is spouse-related or not.
Non-spouse beneficiaries who inherit non-retirement IRAs from deceased account owners must open a new IRA within nine months after their account owner dies to avoid taxes and penalties. Your TIAA wealth advisor can assist with setting up this new account and transfering in assets that have been left behind, and beneficiaries can then choose either taking required minimum distributions over 10 years, or disclaiming it altogether by passing it to someone else as inheritance funds.
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