Who Pays Taxes on IRA Distributions?
Individual retirement accounts (IRAs) offer tax breaks to encourage retirement savings, yet the government still wants its cut of any funds that are withdrawn from an IRA.
If you inherit an IRA, it’s essential that you understand how to balance required minimum distributions (RMDs) against tax consequences. Unfortunately, the rules surrounding RMDs remain complex even after passage of the Secure Act of 2019.
While the government provides tax breaks to encourage individuals to save for retirement, once these accounts are withdrawn they expect their share of taxes due. When withdrawing funds from an IRA account this means paying income tax regardless of how the money was obtained.
Individuals – including beneficiaries and trusts – pay taxes on IRA distributions according to their income tax brackets, and must take required minimum distributions (RMDs) or incur penalties for failing to do so.
Surviving spouses have more options for dealing with inherited IRA assets than most people do; they can choose whether to treat the account as their own or roll it into their own IRA, and spread RMD payments over a 10-year period.
Non-spouse beneficiaries are subject to the 10-year rule; with the exception of minor children who inherit their parents’ IRA and take RMDs as per their life expectancy until reaching 18 years of age. Individuals receiving lump sum distributions from an inherited IRA must pay taxes based on their income tax bracket.
Most spousal beneficiaries who receive distributions from an IRA must report these earnings as income for tax purposes, and must pay both regular income taxes as well as the 10% early withdrawal penalty imposed for taking distributions before age 59 1/2 unless exempt.
Beneficiaries of traditional and Roth inherited IRAs must begin taking required minimum distributions (RMDs) within one year after the account owner dies, calculated using either their spouse’s life expectancy or, in cases involving married couples, jointly using both lives expectancies as the measure for RMD calculation.
Non-spouse heirs may take advantage of the “stretch IRA” option, allowing them to spread distributions over 10 years instead of having to withdraw them all at once, though due to changes in the SECURE Act this option may only be available to certain groups. When considering this strategy it must ensure they have enough other income in order to prevent being moved into a higher tax bracket.
When inheriting an IRA, the rules can differ slightly from those governing original account owners. You generally must take required minimum distributions within 10 years unless exempt; however, spouse beneficiaries have more options.
Non-spouse beneficiaries have several options when it comes to taking distributions from an estate, including setting up an inherited IRA account and taking RMDs over their life expectancy. They could also opt for lump sum withdrawals at their current tax rates; or cashing out Gretta’s IRA and giving $100,000 each of her children, which would trigger no DNI deduction and put Child A into a higher tax bracket, leading to her incurring a 50% penalty upon distribution – something could have been prevented if Gretta had set up separate trusts for each of her children as she did her IRA instead of cashing out Gretta’s IRA before giving the bequests outright.
Government offers tax breaks on IRA investments to encourage retirement savings. They also want to make sure taxes are collected when withdrawing money from an IRA account holder; non-spousal beneficiaries must take required minimum distributions within a 10-year period to comply with this rule.
An IRA withdrawal counts as income for tax purposes, just like interest or earnings from bank accounts, rental property or farms. It should be reported on a beneficiary’s federal income tax return along with other sources of income reduced by allowable deductions and reported as such.
An inherited IRA may include traditional and Roth IRAs, SEP/SIMPLE IRAs and SIMPLE 401(k) accounts. An estate planning attorney can assist in deciding the best ways to settle an inherited IRA after someone passes. While the Secure Act has altered some rules surrounding inherited IRAs, many remain the same; please consult your advisor for the most up-to-date information.
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