What to Expect When You Inherit an IRA
Some inherited assets are tax-friendly, but under new rules, others come with a hefty tax bill. Here is what you need to know to get the most out of a legacy.
Estate Tax Context
Most people will not inherit an IRA, and few will worry about paying estate taxes on an inheritance. In 2021, the federal estate tax does not apply unless an estate exceeds $11.7 million. The Biden administration proposed lowering the exemption, but even that would not affect estates under about $6 million. However, some states have lower thresholds.
If you inherit an IRA from a parent, taxes on mandatory withdrawals could leave you with a smaller legacy than anticipated. With IRAs becoming a significant retirement savings tool, there is a good chance you will inherit at least one account.
The SECURE Act Changes
Prior to 2020, beneficiaries of inherited IRAs could move money into an inherited (or “stretch”) IRA and take withdrawals over their life expectancy, minimizing taxes and allowing untapped funds to grow. However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 changed this.
Most adult children and other non-spouse heirs who inherit an IRA after January 1, 2020, now have two options:
- Take a lump sum
- Transfer the money to an inherited IRA that must be depleted within 10 years after the original owner’s death
Special Rules for Spouses
The 10-year rule does not apply to surviving spouses. They can:
- Roll the money into their own IRA and allow it to grow tax-deferred until required minimum distributions begin at age 72
- For Roth IRAs, they are not required to take RMDs at all
- Transfer the money into an inherited IRA and take distributions based on their life expectancy
Exceptions to the 10-Year Rule
The SECURE Act created exceptions for non-spouse beneficiaries who are:
- Minors
- Disabled or chronically ill
- Less than 10 years younger than the original IRA owner
Roth IRA Considerations
The 10-year rule also applies to inherited Roth IRAs. However, there is an important difference: 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, waiting to take distributions until required will give up to 10 years of tax-free growth.
Tax Implications
Any IRA beneficiaries who are not eligible for exceptions could face a big tax bill, especially if the 10-year withdrawal period coincides with years of other substantial taxable income.
Heirs who cash out their parents’ traditional IRAs will owe taxes on the entire amount, which could push them into a higher tax bracket.
Key Takeaway
Inheriting an IRA comes with important tax considerations that require careful planning. Understanding the rules under the SECURE Act can help you minimize your tax burden and maximize the value of your inheritance. Contact an experienced estate planning attorney to discuss the best strategy for your inherited retirement accounts.
