Individual Retirement Accounts, more commonly known as IRAs, are extremely popular retirement savings accounts used by tens of millions of American citizens. These tax-advantaged accounts allow Americans to save for their retirement throughout their working lives.
In total, Americans currently hold more than $12 Trillion in IRAs. Many of these accounts are drawn down throughout an individual’s retirement years, but in many instances, there is a sizable balance remaining in the account when an individual passes away.
The funds in these accounts are passed down to the individual’s heirs as specified in the terms of their will. But unlike regular, post-tax funds such as those held in a brokerage account, there are special rules enforced by the IRS that could mean heirs face a significant tax bill when they inherit an IRA from a parent or other relative.
Today, we’re explaining what those tax rules are and exploring how they might impact you. We’ll also share how you can minimize your tax liability in the event that you inherit an IRA account when a loved one passes.
How Do IRAs Work?
IRAs are tax-deferred accounts popular among business owners and self-employed individuals. There are several forms of IRA, including Traditional IRAs, Roth IRAs, SEP IRAs, and Simple IRAs. Each works in slightly different ways and is designed for different use cases: the SEP IRA is a good fit for small business owners, whereas Roth IRAs can be used by almost anyone.
In general, IRAs allow individuals to save money for retirement in a tax-advantaged account. Contributions to some forms of IRAs, including Traditional IRAs, are tax-deductible in the year an individual contributes and are instead taxed at the individual’s ordinary income level when they withdraw the money. This allows individuals to build up a considerable amount of money throughout their working lives which they can then use to live off during their retirement.
Once individuals reach a certain age, they are required to take Required Minimum Distributions (RMDs) from their Traditional IRA account. As of 2023, individuals aged 73 or over must take an RMD from their account. The RMD is computed using an IRS worksheet.
If you’d like to learn more about the different types of IRA and determine which represents the best fit for your retirement planning strategy, contact a Strothman Wealth Care advisor.
What Happens When You Inherit an IRA?
It’s common for individuals to pass with a significant balance still in their IRA accounts. This could be anywhere from tens of thousands to millions of dollars. Depending on the individual’s will, this amount is typically first passed to a spouse, and then to children when the second spouse passes.
If you inherit your spouse’s IRA account, there are no taxes to be paid, and this money is considered to be your own. However, if you’re inheriting an IRA from someone you are not married to (such as a parent, grandparent, aunt, or uncle), there are rules in place that govern how you can access these funds.
Before 2020, individuals that inherited IRAs had two choices: to take the money as a lump sum and pay taxes on that amount or to place the funds in a specially-designated inheritance IRA, which could then be drawn down over their lifetime.
However, the passage of the Secure 2.0 Retirement Bill had major impacts on the way that inherited IRAs are taxed. At first, these were not clear, and as a result, the IRS postponed imposing penalties on individuals who did not follow these rules. However, from January 2024 onward, these new rules and the penalties for non-compliance will be in full effect.
So, what exactly are the new tax rules for inherited IRAs? Let’s explore them in a little more detail.
What Are The New Tax Rules for Inherited IRAs?
The updated IRS rules state that once individuals start taking RMDs, their heirs cannot stop taking these distributions once they inherit the account. These distributions should be calculated using the IRS Single Life Expectancy Table, which can be found in IRS Publication 590-B.
The amount that individuals are required to withdraw is driven by a combination of the value of the account and the life expectancy of that individual, based on their age. Heirs must withdraw the entirety of the funds in an inherited IRA from the account within ten years of the death of the original owner of the account, paying ordinary income taxes as they receive these distributions.
Failure to take the RMDs from an inherited account comes with significant penalties. Fines are set at 25% of the amount the individual was required to withdraw, although these are lowered to 10% if the individual compensates for the missed RMDs within two years.
Navigate Tax Planning with Strothman+Co
If you find yourself in this situation, you’re not alone. It’s a complex issue that promises to affect millions of Americans in years to come. If you’ve inherited an IRA, it’s vital that you take steps to plan how to most effectively take distributions from this account within a ten-year window.
Simply taking the RMDs each year may leave you with a gigantic tax bill in the tenth year, when you’re forced to empty the account. At the same time, many IRA accounts are tax-advantaged. Leaving inherited funds in a Roth IRA, for example, allows them to grow tax-free.
Every situation is different and plotting the best path forward for your personal financial situation demands the support of experienced tax advisors and investment professionals.
At Strothman+Co, you’ll find both. Our advisors take a comprehensive approach that considers every element of your financial situation to build a strategy that maximizes your wealth and minimizes your tax liabilities.