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If you inherit a deferred retirement account, such as an IRA or a 401(k), you’ll pay income taxes on the money when you withdraw it. These withdrawals are subject to your marginal tax rate, not the original owners. This can significantly reduce the value of your inheritance, possibly even significantly if you fall into a high tax bracket.
For example, suppose you are in the 32% tax bracket and you just inherited an IRA worth $550,000. This is a significant windfall, but the IRS is going to collect a significant amount from each withdrawal. A financial advisor can help you manage your inheritance and possibly reduce the taxes on this income.
When you inherit a pre-tax account such as an IRA, the IRS has specific rules for how the account must be managed depending on your relationship with the deceased.
Although spouses typically have more flexibility in emptying the inherited account, most non-spouse beneficiaries must empty the account within ten years if the original owner dies after January 1, 2020.
Exceptions to this ten-year rule apply to heirs who are considered “eligible designated beneficiaries,” including:
All other non-spousal heirs, such as adult children (except entities such as charities and some trusts), are considered ‘designated beneficiaries’. They must follow the 10-year rule (or the equivalent 5-year rule if the owner died before 2020). This means that the heir must withdraw all assets from an IRA by December 31 of the year that includes the 10th anniversary of the original owner’s death. No early withdrawal penalties apply to these withdrawals.
If the owner had already started taking RMDs, also known as death after the “required start date” (RBD), then you will also be required to take minimum distributions while owning the IRA. You determine this RMD based on your or the original owner’s longest life expectancy table. Keep in mind that if RMDs apply, you are still required to empty the account within 10 years.
A financial advisor can help you manage an inherited IRA and ensure you follow the proper rules for withdrawing funds.
Suppose you inherit $550,000 in an IRA from your father in 2024 and he died before reaching his RBD. You are considered a “designated beneficiary” (meaning you are not a spouse, minor child, or disabled). Normally you have two general options to clear the account:
You cannot transfer this money to any Roth or traditional IRA you own. However, if you inherited another IRA or Roth IRA, you can deposit the money into that account. The importance of this rule is that it only limits you to accounts that you cannot add new money to.
Suppose here that you fall into the 32% tax bracket. As a single person, this means your income is between $191,950 and $243,725. Unless you can adjust your income from year to year – usually not an option for employed households – every dollar you receive from the IRA will be taxed at no less than 32%.
From there you have a few options:
If you have a major, income-adjusting life event coming up, you can keep this money in place until then. For example, suppose you plan to start a new business or retire within the next ten years. You can leave the IRA in place and then take your withdrawals once your income drops due to the life event.
This is certainly an edge case, but potentially worth taking advantage of if possible.
Let’s say you’re in the middle of the 32% bracket and make about $217,837 per year. If you withdraw all €550,000 at once, you will pay €195,199 in taxes on this withdrawal. This would give you $354,801 to invest as you see fit. This means that most of your withdrawal will fall into the higher tax bracket of 35%.
The alternative to a lump sum payment is a spread payment.
For example, suppose you are at the bottom of the 32% tax bracket and earn $191,950 per year. You can withdraw €55,000 per year for the next ten years and pay 32% on it. This withdrawal would bring your income to $246,950, meaning only about $3,000 of your IRA distribution would be taxed at 35%. The rest would be taxed at 32%.
If there is no income event, this may be your best option to minimize taxes on your IRA withdrawals. By keeping almost all of your withdrawals below the top tax bracket, you’ll pay about $17,336 per year in taxes on each $55,000 withdrawal.
This amounts to $173,360 in total withdrawal taxes, a significant (if not huge) savings compared to the taxes you would pay all at once. You can save about $18,000 in taxes by withdrawing this money in stages, which is money you can then reinvest.
Keep in mind that a financial advisor can help you spread out your distributions to keep your taxable income within your current tax bracket.
When you inherit an IRA, some rules apply. For most non-marital heirs, you must withdraw the money within 10 years and you cannot deposit new assets into the account. And if you do withdraw the money, you will owe income tax on the entire amount. You can manage these withdrawal taxes, but be aware of the tax status of the assets themselves.
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If you’re planning your estate, there’s good news: You can help your heirs avoid the hassle of paying taxes on their inheritances. A Roth conversion during mid-retirement is usually not useful for income planning, but there are estate planning benefits, including tax-free income for your heirs.
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A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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The post My Dad Left Me $550,000 in an IRA, But I’m in the 32% Tax Bracket. How should I structure my recordings? first appeared on SmartReads by SmartAsset.
