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.
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 lets the funds in the account to grow.
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: (i) take a lump sum; or (ii) 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 doesn’t 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.
As a result, IRA beneficiaries who aren’t 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 don’t need the money, delay in taking the distributions until you’re required to empty the account. That will give you up to 10 years of tax-free growth.
Many heirs cash out their parents’ IRAs. However, if you take a lump sum from a traditional IRA, you’ll owe taxes on the whole amount, which might move you into a higher tax bracket.
Transferring the money to an inherited IRA lets you allocate the tax bill, although it’s for a shorter period than the law previously allowed. Since the new rules don’t require annual distributions, there’s a bit of flexibility.
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Reference: Kiplinger (Oct. 29, 2021) “Minimizing Taxes When You Inherit Money”