Can Tax Planning Help Me Keep What I Inherit?
Unless you spend your winters in Aspen and your summers in the Hamptons, you probably do not have to worry about paying federal estate taxes on an inheritance. In 2021, the federal estate tax does not kick in unless an estate exceeds $11.7 million. The Biden administration has proposed lowering the exemption, but even that proposal would not affect estates valued at less than about $6 million.
Kiplinger’s recent article entitled “Minimizing Taxes When You Inherit Money” says that if you inherit an IRA from a parent, the taxes on mandatory withdrawals could mean you will have a smaller inheritance than you anticipated. A little tax planning can change that.
The Old Rules
Prior to 2020, beneficiaries of inherited IRAs or other tax-deferred accounts, like 401(k)s, could transfer the money into an account known as an inherited (or “stretch”) IRA. From there, you could take withdrawals over your life expectancy, allowing you to minimize withdrawals taxed at ordinary income tax rates. This let the funds in the account grow.
The SECURE Act Changed Everything
However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 stopped this tax-saving strategy. Most adult children and other non-spouse heirs who inherit an IRA after January 1, 2020, now have two options: take a lump sum, or transfer the money to an inherited IRA that must be depleted within 10 years after the death of the original owner.
This 10-year rule does not apply to surviving spouses, who can roll the money into their own IRA and allow the account to grow, tax-deferred, until they must take required minimum distributions (RMDs) at 72. Spouses can also transfer the money into an inherited IRA and take distributions based on their life expectancy. The SECURE Act also created exceptions for non-spouse beneficiaries for those who are minors, disabled, chronically ill, or less than 10 years younger than the original IRA owner.
The Tax Impact
As a result, IRA beneficiaries who are not eligible for the exceptions could wind up with a big tax bill, especially if the 10-year withdrawal period is when they have a lot of other taxable income.
The 10-year rule also applies to inherited Roth IRAs. However, although you must still deplete the account in 10 years, the distributions are tax-free, provided the Roth was funded at least five years before the original owner died. If you do not need the money, delay in taking the distributions until you are required to empty the account. That will give you up to 10 years of tax-free growth.
Strategies for Inherited IRAs
Many heirs cash out their parents’ IRAs. However, if you take a lump sum from a traditional IRA, you will owe taxes on the whole amount, which might move you into a higher tax bracket. Again, this is where tax planning becomes essential.
Transferring the money to an inherited IRA lets you allocate the tax bill, although it is for a shorter period than the law previously allowed. Since the new rules do not require annual distributions, there is a bit of flexibility.
If you have questions about minimizing taxes on an inheritance, do not hesitate to contact The Stegall Law Firm for a consultation. We are here to help.
