How Do I Avoid Paying Taxes on an Inherited IRA?
Most IRAs are subject to death taxes, but beneficiaries have ways they can avoid these obligations. By choosing the stretch IRA option instead of paying tax right away on their inheritance account, their tax-deferred status could remain intact for decades after receiving it.
If heirs decide to cash out their account, they will face ordinary income tax rates on any withdrawals made. There may be alternatives available which they should explore instead.
Disclaim the IRA
If you are contemplating disclaiming an IRA, several considerations must be kept in mind. First and foremost is consulting your lawyer. Also keep in mind that disclaiming requires the consent of all contingent beneficiaries who may exist within it.
Consider also whether or not the original owner of the IRA took their required minimum distributions in their year of death; otherwise, their beneficiary must do so before disclaiming the IRA.
Disclaiming partial portions of an IRA or asset is sometimes more palatable than refusing all. But keep in mind that doing this may still have tax repercussions.
Disclaiming an IRA can be a complicated and time-consuming process that must be conducted in writing. Once submitted to a financial organization within nine months of an IRA owner’s death, this deadline cannot be extended; so planning ahead is key if you want to follow all applicable rules regarding disclaiming. Here you can read up more on their rules for disclaiming.
Transfer the IRA to a new custodian
Once someone close to us passes, it can be challenging navigating the complex rules of an IRA, yet there are ways to reduce taxes on an inherited IRA. One option is transferring it to a new custodian; this can help heirs avoid paying taxes when withdrawing it; this may especially prove helpful if the original owner was in a higher tax bracket than their beneficiary.
Transferring an IRA between custodians can be completed using trustee-to-trustee transfer; however, ensure you check each custodian’s policy regarding handling inherited IRAs; some may require such transfers so as not to treat any funds received as taxable distributions.
Spouse beneficiaries may opt to roll their inherited IRAs into traditional IRAs in order to defer the required minimum distribution (RMD) until age 70 1/2, thus avoiding being thrust into higher tax brackets and paying more in taxes.
Take a lump sum distribution
When inheriting an IRA from someone who has passed, several factors should be considered before withdrawing money and taking distributions. A financial advisor who specializes in IRAs should be consulted as the rules can vary depending on who the beneficiary is.
If you are the spouse of a deceased individual, rolling over their IRA into your own retirement account may allow you to avoid paying taxes on distributions as well as avoid incurring penalties such as 10% early withdrawal penalties.
However, if you are not the spouse of the deceased, your options are much more restricted. Non-spouse beneficiaries must take RMDs based on either life expectancy or five-year withdrawal method and pay income taxes on them; additionally they may incur an early withdrawal penalty of 10% when withdrawing before age 59 1/2 – forcing them to take out more funds than desired.
Convert the IRA to a Roth
IRS has strict rules regarding how inherited IRAs should be treated, with 2019’s tax law only adding more complications. But with some planning strategies you could potentially avoid paying taxes on such accounts.
Non-spouse beneficiaries who are minors, chronically ill or disabled and within 10 years of the original account owner can “stretch out” their distributions over their lives if desired, although this process can be complex and needs careful calculation to meet IRS requirements.
Reconverting an inherited IRA to your name may make more sense for those expecting lower taxes in future, Kane said, but may not always be suitable; you might instead wish to consider opening a Roth IRA that allows withdrawal without incurring taxes or any penalties when withdrawing funds from it.
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