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How Do I Avoid Paying Taxes On An Inherited IRA?

Thursday, June 20th 2024

Assuming ownership of an Individual Retirement Account (IRA) can be both a blessing and financial conundrum. While you explore its myriad rules and regulations, one question might come to mind: “How do I avoid paying taxes on an inherited IRA?” It should be noted that direct evasion is illegal and unethical; however, strategic financial planning may reduce tax repercussions; this article explores several tax-efficient strategies for handling an inherited IRA while staying compliant with IRS laws.

Learn the Basics of an Inherited IRA

An Individual Retirement Account, commonly referred to as an “inherited IRA”, allows people to save for retirement with tax advantages. Once an IRA account holder dies, their savings can be passed along to beneficiaries such as spouses, children, or charities – this process is known as beneficiary transfer and known by its shorthand name “inherited IRA.”

An important consideration regarding inherited IRAs is required minimum distributions (RMDs, 1). No matter their age or balance of their account, RMDs must begin in the year following the original account holder’s death and their amount depends on various factors including beneficiary age and account balance.

As with most inheritances, tax implications from an inherited IRA depend upon various variables related to its original account holder’s relationship, type (traditional vs Roth), age threshold requirements and RMD eligibility – meaning any inheritance must be managed efficiently to reduce taxes owed and ensure its benefits reach future generations. Hence, it’s key for beneficiaries of an inheritance to find tax-efficient means of managing it efficiently.

Spousal Inheritance Options

As the spouse of an individual who recently died and left them an IRA, you have several tax-advantageous options at your disposal. One is to treat it like it were your own by designating yourself as its account holder or rolling it over into another qualified account; this enables you to delay taking RMDs until age 72 has been reached.

Treating an inherited IRA as your own enables tax-deferred growth to continue while you potentially realize significant tax savings. Furthermore, distributions made later from this account would likely be subject to your individual income tax rate rather than that of its original account holder – potentially saving even further in taxes!

Stretch IRA Strategy

Non-spouse beneficiaries have access to the Stretch IRA Strategy which allows them to extend tax-deferred growth of an inherited IRA over their lifetimes by taking only required minimum distributions (RMDs), leaving the remainder tax deferred and growing tax free – this allows your inheritance value to maximize further.

SECURE Act of 2019 (2) brought about significant alterations to Stretch IRA strategies. Non-spouse beneficiaries who inherit an account after January 1, 2020, must empty it within 10 years, without specifying annual distributions; giving flexibility for strategic distributions during lower income years so as to minimize tax impacts.

Inheriting a Roth IRA

An inheritance of a Roth IRA brings with it many advantages. Although contributions made using post-tax funds, earnings and withdrawals made after five years from opening an account will be tax-free and thus easily accessible as retirement investments.

As a beneficiary, RMDs still apply; however, they tend to be tax-free distributions. Furthermore, Roth IRAs that you inherit fall under this 10-year rule and allow their balances to accumulate tax free throughout their lifespan before withdrawing them all without tax implications at once.

Charitable Remainder Trusts

Charitable remainder trusts (CRT) are tax-exempt irrevocable trusts designed to reduce taxable income by dispersing income to beneficiaries for a specified time, before giving any remaining amount away to designated charities. CRTs may provide an efficient tax strategy when estate taxes (over $11.7 million as of 2021) must be paid, for managing an inherited IRA account that requires estate tax filings.

By designating a CRT as the beneficiary of an IRA account upon its owner’s death, their assets will pass directly into it instead of remaining unclaimed upon distribution to charity. Tax implications from doing this include twofold benefits for estate tax deduction and income taxes on their account as beneficiaries may potentially avoid being subjected to higher levels of taxes on them in their individual returns.

Consider the Impact of State Taxes

Don’t underestimate the effects of state taxes when considering taxation of an inherited IRA distributions, since not all states comply with federal IRA laws regarding their distributions and may impose different rules regarding how taxes should be assessed upon distributions from an inherited IRA account.

States vary significantly regarding taxation of retirement income. They range from states which exempt all or a part from taxes up to the ones that impose taxes completely. If you inherit an IRA from someone deceased living somewhere else in a completely separate state to where you reside. Therefore it is wise to seek out a professional adviser on tax laws of both states. laws in order to fully know your responsibilities.

Conclusion

Navigating inherited IRAs can be a complex challenge due to their intricate rules and tax implications and may seem inevitable at first. While paying taxes on an inherited IRA might seem inevitable, there are strategies available that can reduce tax burden both legally and ethically – such as using the Spousal Inheritance Option, Stretch IRA Strategy or inheriting Roth IRAs along with charitable remainder trusts as ways out.

Each individual’s circumstances differ significantly, which is why consulting with a financial adviser or tax professional before making decisions regarding an inherited IRA is recommended. By doing this, they can create a personalized strategy that aligns best with both your financial objectives and local tax regulations.

Disclaimer: Please be aware that this article should only be taken as generalized advice, not specific advice for your circumstances. For best advice please seek professional tax or financial planning advice directly.

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2 Comments

  • Natalie says:

    Hi Chris,

    I’ve noticed you don’t have a video for this article. Is this something you guys planned to do?

    Thank you!