There are different rules for inherited retirement accounts.
When you build your own retirement account, you can contribute new money into that portfolio. You can also leave it in place until you need it, subject only to RMDs (Required Minimum Distributions) that kick in around age 73 for pre-tax portfolios.
When you inherit a retirement account, however, you don't have those options. You cannot make new contributions to this portfolio, and in most cases you will have to withdraw it all within 10 years.
This can raise particularly difficult questions for high-income households. If you're on the upper end of tax brackets, pulling money out of a pre-tax portfolio can trigger pretty significant tax payments, costing you much of the money that you're trying to save. For example, say that you inherit $675,000 held in an IRA, but you're currently in the 32% tax bracket.
Here are some things to think about when you approach this account. A financial advisor can help you navigate the nuances of the rules surrounding inherited IRAs and their impact on your taxes. Use this free tool to match with a financial advisor.
The Rules Of Inherited Retirement Accounts
Inheriting a tax-advantaged retirement account, like a 401(k) or an IRA, is subject to different rules than opening and holding one yourself. These rules are based on two categories of heirs known, in the helpful language of the IRS, as "Eligible Designated Beneficiaries" and "Designated Beneficiaries."
Eligible designated beneficiaries include:
- Spouse of the deceased
- Minor children
- Disabled or medically qualifying individuals
- Individuals less than 10 years younger than the deceased
If you are an eligible designated beneficiary, you have broad flexibility in how you handle this account. You can, if you choose, simply leave the money in place and take withdrawals based on your financial plan. If the original owner had not begun taking RMDs, you will take minimum distributions based on your own age. If the original owner had begun taking RMDs, you must continue doing so.
Alternatively, you can transfer the money to another inherited IRA or into your own IRA. In this case, you can manage this money based on the rules of the new account and you will take minimum distributions based on your own age.
Anyone else who inherits a retirement account is known as a "designated beneficiary." In this case, there is a special required minimum distribution known as the 10 Year Rule. This rule requires you to withdraw all funds from the account by December 31 of the 10th year after the original owner's death. For example, if the original owner died on August 1, 2022, you have until December 31, 2032 to empty the account. (Note: If the original owner died before 2020, you must empty the account within five years of the owner's passing.)
There are no early withdrawal penalties for taking funds out of an inherited retirement account. For designated beneficiaries, if the original owner had not yet begun taking RMDs, your only minimum distribution requirement is the 10 Year Rule. If the original owner had begun taking RMDs, you must both follow the 10 Year Rule and continue to take annual minimum distributions. These minimum distributions are based on the longer of either your life expectancy table or the original owner's.
Consider speaking with a financial advisor if you’re interested in professional guidance for your inherited IRA or other estate planning matters.
Taxes and Inherited Retirement Accounts
Inheriting a pre-tax retirement account raises tax issues. Specifically, withdrawing funds from this portfolio will trigger income taxes on the entire amount. This is true whether you move the assets directly into an investment portfolio or liquidate and sell them. The only exception is if you move the assets into another qualifying pre-tax retirement account, such as when an eligible designated beneficiary rolls an inherited IRA into their own.
How you manage these taxes depends on your specific situation.
Here, for example, you are an individual who has inherited $675,000 in an IRA from your father. This makes you a designated beneficiary, so you cannot simply leave the money in place. Nor can you roll the funds into your own IRA. If you have another inherited IRA you can roll the money into that portfolio, which would itself be subject to inherited portfolio rules.
For illustration’s sake, let’s assume here that your father did not begin his RMDs before he passed. Also assuming you do not have a separate inherited IRA, here we have two options:
- Withdraw the money in a lump sum at some point within 10 years
- Take staggered withdrawals ending within the next 10 years
You are in the 32% tax bracket, meaning that you make between $191,950 and $243,725 for the 2024 tax year. For the sake of example, we will assume that you earn $200,000 and currently pay $38,400 in federal income taxes. When you withdraw these assets, no matter what you do with them, you will owe income taxes based on your tax bracket at the time of the withdrawal. This leaves you with a few options.
Take a Full Withdrawal Now
One choice is to withdraw the money right now, in full. This option has the virtue of simplicity. It also has the downside of high taxes, since you will maximize your income tax bracket.
Here, say you move all $675,000 directly into a taxed portfolio. This would make your taxable income for year $875,000, for an effective tax rate of 31.88% and a federal tax bill of approximately $278,958. Of this, $240,558 would be due to your inherited IRA funds being withdrawn. If you take those funds from the portfolio, you would be left with $434,442.
While this maximizes your income taxes, the tradeoff is it also limits future tax issues. Your portfolio's future growth will only be subject to capital gains taxes. These are significantly lower than the taxes on earned income and only apply to profit. For example, say that you leave the funds in an S&P 500 fund for the next 10 years at an average 11% rate of return. This could grow to around $1.12 million which, if withdrawn all at once, would trigger federal capital gains taxes of around $155,094.
In total, after 10 years you would end up around $965,000 post-tax, and you would have paid combined taxes (income and capital gains) of around $551,136.
A financial advisor can help you make calculations and projections based on your circumstances. Get matched with an advisor today.
Take a Full Withdrawal in 10 Years
Alternatively, you could leave the funds in place for 10 years and take a full withdrawal at the last possible moment. This has the advantage of giving this portfolio 10 years of untaxed growth but, again, the disadvantage of maximizing your income taxes.
For example, setting aside questions of inflation, say that you invest in an S&P 500 fund with an average 11% rate of return. This could give you about $1.9 million at the end of 10 years. Then, say you withdraw that all at once due to the 10 Year Rule. This would give you an effective tax rate of 34.88%, and a final federal tax bill of approximately $738,353.
Of these taxes, about $700,000 would be due to your IRA withdrawal. If you pay these taxes from the portfolio, you would be left with around $1.2 million. This strategy may be more expensive than taking an up-front withdrawal, but it may leave you with more money.
Take a Staggered Withdrawal
You could also stagger your IRA withdrawals over the next 10 years.
Staggered distributions are common among households that want to transfer pre-tax portfolios while managing tax brackets. The difficulty here would be sheer volume. Since you must move this money entirely within 10 years, it would likely be impossible for you to stay within the 32% tax bracket that you already pay each year. With your regular annual income assumed at $200,000, any transfers above $50,525 would trigger a higher tax bracket for the 2025 tax year (and that’s not including any other income you may have in a given year, such as dividends or interest).
But here you would need to move at least $67,500 per year to keep within the 10 Year Rule, and that's before accounting for portfolio growth. For example, say that the IRA is invested relatively conservatively for 5% annual growth. At the start of the first year you might withdraw $67,500, bringing the IRA down to $607,500. But by the end of that year it will have grown back to $637,875.
At even just a 5% rate of return, you would need to withdraw about $87,750 per year from this IRA to meet the 10 Year Rule. This would raise your overall taxes to $67,760 each year, about $29,360 in transfer taxes above your ordinary income taxes.
This would give you an estimated of $293,600 of transfer taxes over 10 years.
Wait for a Different Tax Bracket
Finally, you could plan around shifting into a lower tax bracket. This generally requires a significant life change or financial event. For most people, adjusting their income to meet their tax needs is not an option. However, if you are approaching retirement, are changing careers, or even just taking a sabbatical, it might be well worth taking advantage of that opportunity to minimize your taxes on this portfolio.
For example, say that you plan on retiring this year. Instead of taking any income from your own retirement portfolios, you could shift the entire $675,000 in that year. This is a lot of money, so it would still trigger about $204,958 in taxes, but this is significantly less than the taxes you would pay by moving the money while you are working.
Planning for a lower tax bracket is certainly an unlikely, and unusual, situation. However, it may be worth taking the opportunity if you have it. Remember, these examples are simplified for illustrative purposes. Consider consulting a financial advisor for additional guidance.
The Bottom Line
In most cases, when you inherit a retirement portfolio you must move this money within 10 years of the original owner's death. With a pre-tax portfolio, like an IRA, this will trigger income taxes, so it's important to plan for this tax event.
More Tips
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The post My Dad Left Me $675k in an IRA, but I’m in the 32% Tax Bracket. How Should I Structure My Withdrawals? appeared first on SmartReads by SmartAsset.
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