Avoiding Taxes on an Inherited IRA
An inherited IRA can provide significant wealth, yet its tax implications can be complex. A financial professional can assist in devising the optimal strategy for you based on your individual needs and situation.
Assuming you inherit an IRA may seem straightforward, but the IRS wants its share. Here are a few strategies you can employ to limit IRS payment obligations and save yourself some extra expense.
Take a lump-sum distribution.
When taking a lump-sum distribution, all funds will arrive all at once and must be reported on your federal income tax return as taxable income. With respect to traditional IRAs, any early withdrawal penalty (unless over the age of 59 1/2) and taxes at your current income tax rate could apply; additionally if an account contains both nondeductible contributions as well as deductible ones, part of each distribution could potentially be taxed as income.
Naming your children as beneficiaries on an IRA may seem like a nice gesture, but it could become an expensive tax burden if not planned properly. Before withdrawing any money from an inherited IRA, meet with a financial adviser to explore your options and minimize IRS costs; these strategies could help.
Stretch out distributions.
Nonspouse beneficiaries must empty their IRA in 10 years; however, experts advise them that withdrawals don’t have to occur every year at equal amounts; rather they can choose larger withdrawals when their income decreases.
Stretching is a strategy used to extend tax-deferred growth for an IRA for years or decades beyond its original intended lifespan. If one child falls in a higher tax bracket than another, giving them less of the IRA may seem unfair but may actually reduce their tax bill significantly.
An experienced financial advisor can be invaluable when planning for inheritance. Bankrate’s AdvisorMatch allows users to quickly connect with an advisor specializing in this area; if your current advisor doesn’t meet your expectations, simply switch through AdvisorMatch; as the rules surrounding an inherited IRA can be complex and professional assistance is often the best way forward.
Utilize charitable planning.
Due to the complex rules surrounding IRAs and other tax-deferred accounts, beneficiaries often use charitable deductions as a way of offsetting some of the income taxes they will owe upon taking required minimum distributions (RMDs). This is particularly relevant for beneficiaries of traditional IRAs.
This strategy can help beneficiaries avoid paying taxes on an inherited IRA by spreading withdrawals out over their life expectancies. But to take full advantage of it, it’s crucial that they understand its nuances and consult a tax professional.
One tax-savvy strategy would be for the original account owner who is still alive to convert their IRA funds to a Roth IRA, in order to save on taxes since their lower tax rate will apply, as well as to reduce estate tax burden for beneficiaries’ families.
Roll over to another IRA.
An inheritance of an IRA can be an unexpected boon, yet also lead to a considerable tax bill if withdrawals aren’t spread over 10 years and future federal income tax brackets increase, as predicted.
As a spouse, you may be able to avoid this trap by rolling the account over into your IRA and treating yourself as its owner. That way, you can delay its first RMD and take withdrawals according to your own life expectancy rather than that of the original account holder.
Your other option is to divide an IRA between children, tax them accordingly and then repurpose your inheritance in order to reduce its tax burden. A financial expert can help you explore this option further and assist with restructuring it to minimize tax obligations.
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