Warning: You might have to pay taxes on Inherited IRAs. If you’ve inherited an IRA, you won’t have to pay a penalty on early withdrawals if you take money out before age 59½. However, you may have to make those withdrawals earlier than you’d wanted. Doing so may trigger additional income taxes, and even push you into a higher tax bracket. The IRA has always been a complicated retirement account. While changes from the SECURE Act have simplified some things, it’s made others more stringent.
A recent article titled “How Do I Avoid Paying Taxes on an Inherited IRA?” from Aol.com explains how the traditional IRA allows tax-deductible contributions to be made to the account during your working life. If the IRA includes investments, they grow tax—free. Taxes aren’t due on contributions or earnings until you make withdrawals during retirement.
A Roth IRA is different. You fund the Roth IRA with after-tax dollars, earnings grow tax-free and there are no taxes on withdrawals.
With a traditional inherited IRA, distributions are taxable at the beneficiary’s ordinary income tax rate. If the withdrawals are large, the taxes will be large also—and could push you into a higher income tax bracket.
If your spouse passes and had an inherited IRA, you may take ownership of it. It is treated as if it were your own. However, if you inherited a traditional IRA from a parent, you have just ten years to empty the entire account and taxes must be paid on withdrawals.
There are exceptions. If the beneficiary is disabled, chronically ill, or a minor child, or ten years younger than the original owner, you may treat the IRA as if it is your own and wait to take Required Minimum Distributions (RMDs) at age 72.
Inheriting a Roth IRA is different. Funds are generally considered tax-free, as long as they are considered “qualified distributions.” This means they have been in the account for at least five years, including the time the original owner was alive. If they don’t meet these requirements, withdrawals are taxed as ordinary income. Your estate planning attorney will know whether the Roth IRA meets these requirements.
If at all possible, always avoid immediately taking a single lump sum from an inherited IRA. Wait until the RMDs are required. If you inherited an IRA from a non-spouse, use the ten years to stretch out the distributions.
If you need to empty the account in ten years, you don’t have to withdraw equal amounts. If your income varies, take a larger withdrawal when your income is lower and take a bigger withdrawal when your income is higher. This can result in a lower overall tax liability.
If you’ve inherited a Roth IRA and funds were deposited less than five years ago, wait to take those funds out for at least five years. When the five years have elapsed, withdrawals will be treated as tax-free distributions.
One of the best ways for heirs to avoid paying taxes on an IRA is for the original owner, while still living, to convert the traditional IRA to a Roth IRA, paying taxes on contributions and earnings. This reduces the taxes paid if the owner is in a lower tax bracket than beneficiaries, and lets the beneficiaries withdraw funds as they want with no income tax burden.
Reference: Aol.com (Feb. 25, 2022) “How Do I Avoid Paying Taxes on an Inherited IRA?”