Inheriting a Tax-Deferred Retirement Account: Navigating the Complexities
If you’ve inherited a tax-deferred retirement account, such as an IRA or 401(k), you’re likely to face a significant tax burden when you withdraw the funds. The withdrawals are subject to your marginal tax rate, which can reduce the value of your inheritance substantially, especially if you’re in a high tax bracket.
Understanding the Rules
When inheriting a pre-tax account, the IRS has specific rules for managing the account, depending on your relationship to the deceased. Spouses typically have greater flexibility, while non-spouse beneficiaries must empty the account within 10 years if the original owner died after January 1, 2020. Exceptions apply to eligible designated beneficiaries, including minor children, disabled or chronically ill individuals, and those not more than 10 years younger than the deceased.
Managing Your Inheritance
A financial advisor can help you navigate the complexities of inheriting an IRA and ensure you follow the proper rules for withdrawing money. Let’s consider an example: you inherit $550,000 in an IRA from your dad in 2024, and he died prior to reaching his required beginning date (RBD). As a designated beneficiary, you have two general options for emptying the account: taking a lump sum withdrawal or staggered withdrawals over the next 10 years.
Tax Implications
If you’re in the 32% tax bracket, every dollar you take from the IRA will be taxed at no less than 32%. You have a few options to minimize taxes:
- Keep the money in place until a significant income-adjusting life event, such as starting a new business or retiring, when your income drops.
- Take a lump sum withdrawal, but be aware that this may push you into a higher tax bracket.
- Opt for staggered distributions to keep your taxable income within your current tax bracket.
Staggered Distributions: A Tax-Efficient Approach
By taking out $55,000 per year for the next 10 years, you can pay 32% on almost all of that, minimizing the amount taxed at 35%. This approach can save you approximately $18,000 in taxes compared to taking a lump sum withdrawal.
Estate Planning Benefits
If you’re planning for your estate, consider a mid-retirement Roth conversion, which can provide tax-free income for your heirs. A financial advisor can help you build a comprehensive retirement plan and navigate the complexities of inheriting an IRA.
Finding the Right Financial Advisor
SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one is right for you.
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