Inherited IRA Taxes: What to Know Before You Take the Money
Hi friends,
Say your parents sit down with you and explain how they plan to divide their estate. Part of what you may eventually inherit is a substantial traditional IRA. At first, $500,000 in an IRA may sound a lot like inheriting $500,000 in another investment account or property.
From a tax standpoint, it isn't necessarily the same at all.
Traditional IRAs come with their own tax rules, and what you do after inheriting one can have a significant effect on your tax return. Before taking money out, it helps to understand what you actually inherited and what choices you may have.
Quick Summary
If you inherit a traditional IRA, taxable distributions are generally treated as income to you. Most non-spouse beneficiaries are also subject to a 10-year deadline for emptying the account. That doesn't necessarily mean you should withdraw everything immediately or divide it evenly over ten years.
An Inherited IRA Isn't the Same as Other Inherited Assets
One of the biggest differences involves something called basis.
Basis is essentially the amount used to determine taxable gain when certain property is sold. Many inherited assets, such as real estate and taxable investments, generally receive a new basis based on their value at the owner's death. You may have heard this called a step-up in basis.
A traditional IRA works differently. The income tax that has been deferred inside the account doesn't simply disappear when the owner dies. When a beneficiary takes taxable distributions from an inherited traditional IRA, those distributions generally become taxable income to the beneficiary.
That means two assets with the same $500,000 value can create very different tax consequences for the person inheriting them.
What Is the 10-Year Rule for Inherited IRA Taxes ?
For many non-spouse beneficiaries, current federal law requires the inherited account to be emptied by December 31 of the tenth year following the original owner's death.
There is an important wrinkle. Depending on whether the original owner had reached the point when they were required to take their own required minimum distributions, or RMDs, the beneficiary may also need to take annual distributions during those ten years.
There are different rules for surviving spouses and certain other beneficiaries, so don't assume the 10-year deadline is the only rule that applies to your account. The IRS guidance for retirement account beneficiaries explains the different beneficiary categories and distribution rules.
Before You Cash Out an Inherited IRA
You usually don't have to take the entire inherited IRA at once. More importantly, having the ability to take a large distribution doesn't necessarily mean it makes sense from a tax perspective.
Suppose you inherit a $300,000 traditional IRA while you're in your highest earning years. Taking the entire taxable balance in one year could add a substantial amount of income to your tax return and potentially push some of that income into higher tax brackets.
But automatically dividing the account into ten equal withdrawals isn't necessarily the right answer either. Your income may change from year to year. Retirement could be approaching. You could have an unusually low-income year, or annual RMDs could apply to your particular inherited account.
The 10-year rule gives many beneficiaries a deadline. It doesn't give everyone the same withdrawal strategy.
What Should You Do Before Taking the Money?
First, find out exactly what type of retirement account you inherited and which beneficiary rules apply to you. The IRS inherited IRA and RMD guidance is a good place to understand the federal rules, but deciding when to take taxable distributions requires looking at your own numbers.
If the account is substantial, this is a good time to talk with us or your own tax professional before taking a large distribution. A tax consulting & optimization session can help you look at the timing of distributions and how the inherited IRA fits into your overall tax picture before the taxable income is already on your return.
You may also want to read our article about step-up in basis for inherited property because retirement accounts and other inherited assets can receive very different tax treatment..
Frequently Asked Questions
Frequently Asked Questions
Do I have to pay taxes on an inherited IRA?
Distributions from an inherited traditional IRA are generally taxable income to the beneficiary. Inherited Roth IRAs generally receive more favorable income-tax treatment, although distribution rules can still apply.
Do I have to cash out an inherited IRA immediately?
Usually not. Many non-spouse beneficiaries must empty the account within ten years, but that generally doesn't mean the entire account has to be withdrawn immediately.
Do I have to take money out every year during the 10-year period?
It depends. Annual RMDs may be required depending on the circumstances, including whether the original owner had reached their required beginning date before death.
Is the old "stretch IRA" completely gone?
No. Certain eligible designated beneficiaries, including surviving spouses and some disabled or chronically ill beneficiaries, can qualify for different distribution rules. Most other non-spouse beneficiaries are subject to the 10-year rule.
Is it better to take an inherited IRA all at once or over several years?
There isn't one answer that works for everyone. Your income, required distributions, retirement plans and other tax circumstances can all affect when it makes sense to take distributions.
If you've inherited a substantial retirement account, don't feel like you have to figure out the tax consequences after you've already taken the money. Talk with us or your own tax professional first and make the distribution decision with the full tax picture in front of you.
How can Apple Blossom Tax Service help?
Every family's situation is different. During a Tax Consulting & Optimization Session, we can review your inherited IRA, discuss the potential tax implications of when to cash in, and help you understand your options before you make a final decision.
Warmly,
Melissa Ochoa
Enrolled Agent & Owner, Apple Blossom Tax Service
Serving Sebastopol and Sonoma County
Coming soon: Keep an eye out for an upcoming Apple Blossom Tax Service Estate & Trust informational workshop. We'll be sharing details soon.
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