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When a loved one leaves behind an IRA, do you have a plan to manage the tax obligations that come with it?
Many people inherit an Individual Retirement Account (IRA). However, inheriting an IRA is not as easy as inheriting money outright. Read this Periscope to learn more about the IRS rules around inheriting an IRA*. And keep your eyes open for other Periscopes on what happens when someone inherits a spouse’s IRA.
Advantages of an Inherited IRA
One big advantage of an inherited IRA is that the beneficiary may defer income taxes. The IRA will either be a traditional tax-deferred IRA or it will be a Roth IRA. A traditional inherited IRA defers taxes until the beneficiary makes withdrawals. At that point, the beneficiary must pay taxes at their income tax rate. Importantly, a decedent does not pay income tax; the inheritor pays income tax.
In an inherited Roth IRA, the beneficiary never pays taxes again! The inheritor must make distributions, as discussed below, but the distributions are income tax free. For this reason, many retirees want to go tax free and leave their kids a Roth IRA; this is particularly powerful if the inheritors are in a higher income tax bracket than they are.
Disadvantages of an Inherited IRA
An inherited IRA forces the beneficiary to make distributions. The SECURE Act forces all of the money to be removed from an IRA within 10 years, or faster. The money withdrawn is subject to income tax, if it is a traditional inherited IRA. The inheritor may make withdrawals faster, if they so choose, but they must pull all the money out by the 10th year after the decedent’s death.
A second disadvantage is the Lifetime Expectancy Payment, LEP. The LEP forces the inheritor to make annual distributions based off their age. They will look up a factor in the IRS single lifetime table 1 and make an annual LEP. If it is a traditional inherited IRA, they will pay income tax on the distribution.
Similar information:
- IRAs: Roth, Rollover, Inherited and More
- Which IRA to Choose? Traditional vs Roth IRA – Differences & Which is Better Explained
- SECURE Act and How it Affects Retirees
* IRA stands for individual retirement account. An IRA provides tax advantaged retirement savings.
MINI FAQ
Navigating an Inherited IRA
What is the “10-Year Rule” for inherited IRAs?
Under the SECURE Act, most non-spouse beneficiaries are required to fully distribute the assets of an inherited IRA by December 31 of the tenth year following the original owner’s death. This shift from the older “stretch” rules means that beneficiaries must carefully plan the timing of these withdrawals to manage the potential impact on their own income tax bracket.
How do taxes work on an inherited Traditional IRA vs. an inherited Roth IRA?
With a Traditional inherited IRA, the beneficiary generally owes income tax on every dollar withdrawn, as the original owner had not yet paid taxes on those funds. Conversely, with an inherited Roth IRA, distributions are typically income-tax-free, provided the account was open for at least five years. In both cases, the inheritor—not the decedent—is responsible for following the distribution rules.
What is a Lifetime Expectancy Payment (LEP)?
An LEP is an annual distribution that some beneficiaries may be required to take based on their own age and IRS life expectancy tables. While the 10-year rule has replaced the “stretch” option for many, certain “eligible designated beneficiaries” (such as minor children or chronically ill individuals) may still use this method to spread distributions over a longer period.
The tax information contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Disclaimer: The information provided in this blog post is for general informational purposes only and should not be construed as financial or legal advice. Please consult with a qualified professional for advice regarding your specific situation.
DISCLOSURE: Client stories included in this blog reflect hypothetical client situations that represent those commonly encountered by AIWM representatives.
