Do you have to pay taxes on an inherited ira

While inheriting money is typically a good thing, newer individual retirement account rules may leave some heirs with a smaller windfall.

Thanks to the Secure Act of 2019, certain heirs now have less time to take IRA withdrawals. The law stopped the so-called stretch IRA, which allowed non-spouse beneficiaries to "stretch" distributions over their lifetime.

The new law, applying to IRAs inherited on Jan. 1, 2020, or after, requires some heirs to deplete accounts within 10 years and they may owe levies on distributions, known as the "10-year rule." 

More from Personal Finance:
'Inflation is the silent killer,' as many retirees are feeling the sting
State-run 'auto IRAs' are gaining steam as a retirement savings solution
Congress wants to make more changes to the U.S. retirement system

These guidelines may place a tax burden on higher earners or those receiving large balances, financial experts say.

"I'm not sure this has been around long enough for even estate-planning attorneys to really understand the shift and the implication," said certified financial planner Teresa Bailey, wealth strategist at Waddell & Associates in Nashville, Tennessee.

But there are ways to limit the tax sting. Here's what IRA account holders and beneficiaries need to know.

The 10-year rule

Most IRA beneficiaries fall into two categories: those who must follow the 10-year rule and those who may stretch withdrawals over their lifetime.

"Depending on who you choose [as a beneficiary], the net amount of money that goes to them could be different," said Karl Schwartz, CFP and CPA at Team Hewins in Boca Raton, Florida.

watch now

VIDEO1:0501:05

Here's how to decide if a Roth or traditional IRA will save you more money

One-Minute Money Hacks

Spouses, minor children, disabled or chronically ill heirs and certain trusts may still extend IRA disbursements throughout life. Those who are 10 years younger or less than the account owner may also qualify.

However, everyone else, such as adult children, must empty their inherited IRAs within 10 years. For example, if a parent passed away in June, their adult child has this year, plus 10 more, to take distributions.

"It's a 10-year rule, but it could technically turn into 11 years, depending on when someone passes," said Bailey.

Strategies for IRA owners

One strategy for IRA owners is to shift their balance from pre-tax to after-tax with a so-called Roth IRA conversion, paying taxes on contributions and earnings.

"It would probably make sense if they're in a tax bracket that's lower than their beneficiaries," said Schwartz. 

I think the application of the Roth conversion could be pretty incredible.

Teresa Bailey

Wealth strategist at Waddell & Associates

Although the beneficiary still has to take out the funds within 10 years, they wouldn't owe taxes on the inherited balance.

"I think the application of the Roth conversion could be pretty incredible," Bailey added.

IRA owners in a lower tax bracket may also reduce the burden for beneficiaries by withdrawing money, paying levies and putting the funds into a brokerage account for their heirs.

However, it wouldn't save as much taxes as the Roth conversion, Schwartz said.

Tactics for beneficiaries

Although the 10-year rule offers less flexibility, there are other ways to reduce taxes.

"As soon as I open [an inherited IRA] now, I have an active game plan put together," Bailey said.

In some cases, it makes sense to split distributions over 10 years or 11 years. However, those with variable income, such as business owners, may keep the money invested until there is a good time to take it out.

"That's one of the biggest potential uses of this 10-year window," Bailey said. "You could take one or two very large distributions at an opportune moment."

Someone may withdraw money in a lower-income year or when there's a "pretty sizeable drop" in the market and reinvest it elsewhere, she said. 

For example, those eligible for a health savings account may contribute up to $7,200 in 2021 for a family plan. The HSA deduction may help offset the tax on the IRA disbursement. Plus, they may invest and grow the HSA funds tax-free.

Tax rules on individual retirement accounts (IRAs) are different for inherited IRAs. Some differences are positive. For instance, someone who inherits an IRA doesn't pay a penalty for early withdrawal before age 59 1/2. On the negative side, special rules for inherited IRAs may force beneficiaries to take the money out sooner than they'd like. That can trigger an unwanted income tax obligation and even increase taxes on other income by pushing the beneficiary into a higher tax bracket. Fortunately, there are ways to avoid or reduce the potential tax bite on an inherited IRA. A financial advisor may be a big help in walking you through your options. Try using SmartAsset's free advisor matching tool to find advisors that serve your area.

IRA Basics

A traditional IRA lets you make tax-deductible contributions to your own retirement savings plan. In addition, earnings from investments made with finds in an IRA grow tax-free. You don't pay taxes on either contributions or earnings until you start making withdrawals later on after retiring.

A Roth IRA is a retirement savings vehicle that you fund with after-tax dollars. Roth IRA contributions don't get you a tax deduction. But earnings on funds in a Roth IRA also grow tax-free and, unlike a traditional IRA, you don't owe income taxes on Roth withdrawals once you start taking money out in retirement.

Tax Consequences of Inheriting a Traditional IRA

The main thing to remember about inheriting a traditional IRA is that distributions are generally taxable at the beneficiary's ordinary tax rate. If you inherit an IRA and take money out of it, you'll pay income taxes on it. If the withdrawal is big enough to lift your income into a higher bracket, you may owe more taxes on the rest of your income as well.

Inherited IRAs do qualify for some special treatment, however. For instance, while withdrawals taken by the original account owner before age 59 1/2 are ordinarily subject to a 10% penalty, a beneficiary doesn't have to pay that penalty even when withdrawing at a younger age.

Story continues

Beyond that, much depends on just who bequeathed you the IRA. If the original owner was your spouse, you can simply take ownership of the IRA. Then, just as if you were the original owner, you can wait until age 72 to start taking any required minimum distributions (RMDs) and paying any taxes due on them.

Exceptions to the Rule

avoid taxes on inherited ira

If you inherited the IRA from someone other than a spouse, you can't wait for RMDs to start. Instead, you have just 10 years from the time you inherited the account to withdraw and pay taxes on the entire amount.

Exceptions apply if you are disabled, chronically ill or an underaged child. Another exception applies if you are less than 10 years younger than the original owner of the IRA. In all these cases, you can still treat the IRA as your own and wait until RMDs start at age 72.

Tax Consequences of Inheriting a Roth IRA

Funds withdrawn from an inherited Roth IRA are generally tax-free if they are considered qualified distributions. That means the funds have been in the account for at least five years, including the time the original owner of the account was alive. If they don't meet the qualified distribution criteria, funds withdrawn from an inherited Roth IRA are taxed as ordinary income.

Once again, the relationship between beneficiary and original owner makes a difference. A Roth IRA inherited from a spouse can be treated as if it were the beneficiary's own account. This means the new owner can take tax-free withdrawals at his or her option.

If the Roth IRA came from anyone else, however, the beneficiary has to take RMDs just as if it were a traditional IRA. That means withdrawing the full amount within 10 years. Also, the same exceptions for disabled, chronically ill and underage beneficiaries apply.

Inherited IRA Tax Strategies

One inherited IRA tax management tip is to avoid immediately withdrawing a single lump sum from the IRA. Instead, wait until RMDs are due or, if you got the IRA from a non-spouse, stretch withdrawals over 10 years.

RMDs are taxable and can change your tax bracket and increase your overall tax burden. But if, as is often the case, you are in a lower tax bracket when you have to start taking them, you may be able to save on taxes by deferring withdrawals until the RMD rules force you to start.

If you have to empty the account in 10 years, you don't have to withdraw equal annual amounts. You can instead wait until when your income is lower than normal, then take a larger withdrawal from the inherited IRA. Similarly, if your income is higher in another year, you can take less that year, as long as the entire amount is withdrawn after 10 years. This income-leveling strategy can result in a lower overall tax outlay.

Other Strategies to Be Aware of

If you inherited a Roth IRA with funds deposited less than five years ago, one strategy is to simply wait before taking those funds out. When the five-year period has elapsed, withdrawals will be treated as tax-free qualified distributions.

One of the most effective tax-management strategies has to be undertaken by the original owner before he or she dies. With this approach, the owner converts a traditional IRA to a Roth IRA, paying any taxes due on contributions and earnings.

This can reduce the overall taxes paid on the funds if the original owner is in a lower tax bracket than the intended beneficiaries. And a Roth IRA conversion would allow the beneficiary to withdraw the funds later on without incurring income taxes.

Bottom Line

avoid taxes on inherited ira

A person who inherits an IRA can expose themselves to significant tax consequences if they simply withdraw the money from the account in a single lump sum. By stretching withdrawals out over years, on the other hand, they can keep taxes as low as possible while still benefiting from the inheritance.

Tips on Saving for Retirement

• If you anticipate inheriting or bequeathing an IRA, consider working with a financial advisor. Finding a qualified financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

• If you're planning for retirement on your own, it pays to be in the know. SmartAsset has you covered with tons of free online resources to help. For example, check out our free retirement calculator and get started today.

  Does an inherited IRA count as income?

  Consider all your options when taking RMDs and other distributions from an inherited IRA. Generally, your distribution is included in your gross income and will be subject to ordinary state and federal income taxes. Once funds are distributed from an inherited account, the money will have to be included in income.

  Do I need to report inherited IRA to IRS?

  Death and the Traditional IRA However, distributions from an inherited traditional IRA are taxable. This is referred to as “income in respect of a decedent.” That means if the owner would have paid tax, the income is taxable to the beneficiary.

  Is an inherited IRA tax free?

  Inherited Roth IRAs Withdrawals of contributions from an inherited Roth are tax free. Most withdrawals of earnings from an inherited Roth IRA account are also tax-free. However, withdrawals of earnings may be subject to income tax if the Roth account is less than 5-years old at the time of the withdrawal.