Avoiding Paying Taxes on an Inherited IRA
IRAs can become complex when passed to beneficiaries. To ensure you understand how an inherited IRA works, please seek the advice of a financial or tax expert.
Some beneficiaries opt for a lump-sum withdrawal, which can incur an exorbitant income tax bill. But there are ways to minimize tax liabilities such as taking RMDs over 10 years.
Taking a lump sum
IRA inheritance rules can be complex and have a profound effect on your taxes. While the IRS offers comprehensive rules, it’s wiser to work with a professional specialized in inheriting IRAs who can guide you through them more smoothly and help avoid costly mistakes. A fee-only financial planner provides impartial advice that could save both parties considerable money in fees.
Assuming you inherit an IRA can be an unexpected boon, but its assets must be used carefully. Cashing it out could incur a costly tax bill; to protect against that possibility, take required minimum distributions (RMDs) beginning on December 31 of the year following your original owner’s death and no later than December 31 each year thereafter.
Many heirs choose to take withdrawals over their lifetime, but new rules could make that option less appealing. A recent court decision has made it harder for nonspouse beneficiaries to protect their inherited IRAs from creditors and requires that it be depleted within 10 years.
Rolling it over
As inheriting an IRA can be complex, there are ways to minimize any costly errors. By carefully considering all of your options and taking the time to weigh them carefully before making irrevocable decisions it’s possible to maximize investment gains and reap years of tax-advantaged growth. Before making any permanent decisions it is crucial that professional guidance be sought prior to taking irreversible steps.
If you take out your money all at once, the tax burden may increase depending on its size. Your income tax bracket could even change due to this decision.
Before 2020, one way to lower your tax bill from an inherited IRA was by rolling it into a beneficiary IRA and taking required minimum distributions (RMDs) over your life expectancy. Unfortunately, the IRS has changed these rules, so before making any changes it is advisable to seek professional advice first and properly title the account so it will be recognized as an inherited IRA so brokerages cannot claim it as cash-outs.
Assuming ownership
If you inherit an IRA, it is crucial that you understand all your options. Otherwise, you could end up paying more taxes than necessary and paying extra penalties and interest charges than necessary. Some experts advise seeking advice from a financial advisor with expertise in handling inherited IRAs.
As with any inheritance, it is also essential that an IRA be properly named. A good way of ensuring this happens is titling it as follows: “Jane Doe deceased, F/B/O (for the benefit of) Jimmy Doe beneficiary”. Otherwise, incorrect titling could lead to accidental cash-out.
Many beneficiaries make the mistake of taking a lump sum distribution in year 10, which will lead to a steep tax bill. Instead, their distributions should be spread out throughout their lives to reset the IRS’s required minimum distribution schedule and avoid incurring early withdrawal penalties of 10% early withdrawal penalty and maximize tax benefits.
Converting it to a Roth
If a non-spouse heir decides to convert their inherited IRA to an individual Roth account, they can keep it intact and enjoy tax-free growth over the years – plus no RMDs until the original account owner would have turned 72!
Dependent upon their income, withdrawals could push an heir into a higher tax bracket. To minimize their tax liabilities, they can convert their IRA to a Roth in a taxable year; just be wary about adding pretax funds at once!
No matter their strategy of choice, heirs should seek professional guidance to ensure compliance with IRS rules and maximize growth. A certified financial planner will be able to explain each option’s pros and cons before providing tailored advice based on individual circumstances. It would also be wise to consult a specialist who specializes in IRA inheritances as they could help heirs avoid costly errors.
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