How to Avoid Paying Taxes on an Inherited IRA
If you inherit an IRA, it’s essential that its tax implications are carefully considered. Beneficiaries typically must begin taking required minimum distributions (RMDs) by December 31 of the year following their decedent’s passing.
Here are a few strategies you could employ to avoid paying taxes on an inherited IRA:.
Roll the account into an existing IRA
Behaving as though the account were your own by rolling it into an IRA you own allows you to spread out distributions over multiple years, using bracket topping. This strategy helps reduce taxes while permitting its remaining balance to continue growing tax-deferred.
The original owner was likely required to take annual required minimum distributions (RMDs), based on their age and life expectancy. If this doesn’t suit you, consider converting it to a Roth IRA for investment purposes or convert to another account type altogether.
If you decide to cash out the account, income taxes must be withheld on any taxable portion of withdrawals. To avoid incurring the 10% early withdrawal penalty if you’re older than 59 1/2 and withdrawal within 10 years. It would be beneficial for you to consult a financial advisor in order to understand more fully how inherited IRAs work and its regulations.
Take a lump-sum distribution
If you do not wish to consolidate the account into an existing IRA, there are still other options. Take either a lump-sum distribution and invest the proceeds or spread withdrawals over 10 years for tax efficiency. Both options could help minimize taxes.
Before making any decisions, consult a tax professional first. For instance, taking a lump-sum distribution could require paying income tax on its entirety and sacrifice potential tax-deferred growth opportunities.
Option 2 is to “take over” or assume ownership of an IRA account, typically by making a trustee-to-trustee transfer between financial institutions that hold it and another custodian. Once this transfer takes place, the IRS will treat it as though you had always contributed to it and your life expectancy rule for required minimum distributions will reset based on your age – an ideal solution if either party was previously married and you’re under age 59 1/2.
Stretch distributions over a period of 10 years
Owners of an IRA may opt to distribute their assets gradually over a 10-year period, which allows them to avoid having to distribute all their funds at once. Before taking this route, it is wise to consult a tax specialist.
Under the SECURE Act, nonspouse beneficiaries must deplete any traditional IRA they inherit within 10 years, which puts an end to popular stretch IRA strategies such as those using stretch IRAs as stretcher accounts. Only spouse beneficiaries and certain special categories receive extended deferral periods.
Withdrawals from an inherited IRA are taxed at ordinary income rates and may also trigger other taxes and push you into higher tax brackets, so the smaller your distributions, the less tax burden there will be overall. One way to replicate flexible payments and tax deferral of stretch IRAs is through setting up an irrevocable trust with life insurance – which should pay charity first before dispersing benefits to beneficiaries; if clients are particularly charitable-minded this strategy may make sense.
Disclaim the account
If a non-spouse beneficiary wants to disclaim an IRA, they must do so within nine months after either the death of its original account holder, or before taking distributions. A written document must be provided to the financial institution holding their IRA account in order for this process to work effectively.
Once a disclaimer is filed, the next beneficiary will begin receiving distributions over their life expectancy. Before making this decision, however, it’s wise to consult a tax professional as disclaiming could trigger federal generation-skipping transfer (GST) tax liability.
Lily disclaiming an IRA would allow its proceeds to pass to Daisy and Iris, Rose’s grandchildren. However, this would trigger GST tax should Lily have an estate that exceeds gift and estate tax exemption levels; thus it is important that beneficiaries consult a tax professional prior to making decisions regarding these matters; in many instances a family lawyer may help facilitate this process.
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