Editor’s Note: This story originally appeared on Boldin.
When you inherit an IRA, it’s more than just a financial windfall; and it is a responsibility.
The rules governing inherited IRAs are complex and can have a big impact on how much you end up getting after taxes, as well as how you manage your money over the long term.
Whether you’re navigating the Secure Act rules, balancing tax considerations, or planning for your retirement goals, having a thoughtful retirement plan is essential.
Read on for important factors to consider when taking distributions from an inherited IRA, ensuring you make the most of your inheritance while avoiding costly mistakes.
Let’s break it down step by step, so you can align your decisions with your financial goals and obligations.
The rules for your inherited IRA distribution
The distribution rules for inherited IRAs depend on several factors, including:
- Your relationship with the original account holder
- Whether it’s a Roth or a traditional IRA
- Whether your beneficiary passed before or after 2020 (due to changes introduced by the Safeguards Act)
- Whether or not the original account owner had already started taking required minimum distributions (RMDs).
When you model your earned IRA in the Boldin Retirement Planner, you’ll see the distribution rules that should apply to your account. Understanding the rules is important to avoid penalties.
An inherited IRA may be subject to required annual distributions and/or a 10-year distribution period.
And while a 10-year distribution period may sound like a highway to tax-deferred growth, delaying distributions until year 10 has the potential to push you into a higher tax bracket and increase your tax bill.
Avoid penalties on your earned IRA
You will want to follow the distribution requirements that apply to your account.
Failure to do so can result in significant penalties (typically 25% of the missed distribution amount).
Required distribution options for your inherited IRA
You have several options for making the necessary withdrawals. Consider these criteria:
Tax issues: This is a big consideration. Required withdrawals from an inherited IRA can put you in a higher tax bracket. Learn more about reducing taxes on inherited IRA distributions.
Your financial goals: If taxes are not a concern, you may be able to withdraw money to prepare for your financial goals. Do you need immediate income? Or can you let the account grow?
Match your withdrawals to specific goals such as paying off debt, funding retirement, or covering major expenses.
Options to reduce taxes on inherited IRA distributions
Within the distribution rules of inherited IRAs, you may have options. You can withdraw money in different amounts and at different times. And the decisions you make about your distribution will have a big impact on taxes.
If you distribute the entire IRA in the first year or delay the distribution until year 10, you may be pushed into a higher tax bracket for that year and suffer additional negative consequences.
Looking for ways to spread inherited IRA distributions over a 10-year period can help you manage income taxes by taking advantage of lower tax brackets.
And smart distribution strategies can reduce the income tax liability of an inherited IRA.
Strategies to consider
Space out distribution:
- Another strategy to consider is to split the distribution over a 10-year period. This allows you to benefit from tax-deferred income while also managing taxes.
Fill in the bottom brackets:
- You may want to explore using taxable distributions to “fill” a marginal tax bracket each year but avoid going into the next, higher bracket.
Check out the low tax years:
- Waiting until retirement to take distributions may lower your overall tax bill.
To minimize tax implications:
- You may be able to pay more taxes on inherited IRA withdrawals by increasing contributions to your retirement accounts. Maximizing your retirement contributions can help keep the tax impact of inherited IRA distributions to a minimum.
- Another possible strategy to reduce the tax impact of inherited IRA withdrawals is to increase donations to charities and/or a donor-advised fund.
When can you customize your inherited IRA withdrawal method?
If any of the following situations apply to you, you may need a customized approach to manage the impact of inherited IRA distributions.
Meeting MAGI requirements
If you need to meet the MAGI (adjusted gross income) requirements for any of the following, you’ll want to evaluate the impact of inherited IRA distributions on your MAGI and create a strategy that allows you to meet your distribution requirements while staying below desired MAGI.
Tax deduction:
- Student loan interest deduction
Tax credits:
- Education-related tax credits — American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC)
- Premium Tax Credits (PTC) that can lower monthly premiums when you buy health insurance in the marketplace
- Child Tax Credit (CTC)
- Earned Income Tax Credit
- Conservator’s Credit
Retirement contributions:
- Your MAGI affects whether your contributions to employee-sponsored retirement accounts, such as traditional IRAs, are deductible, and whether you can contribute the maximum amount, a partial amount, or nothing at all to a Roth IRA.
Your age
If you are 63 or about to turn 10, an IRA distribution from an inheritance may increase your adjusted gross income (AGI) above the adjusted monthly income (IRMAA) and increase your Medicare costs.
Your Social Security benefits
If you receive Social Security benefits, the percentage of Social Security benefits subject to tax is determined, in part, by your AGI.
If you don’t need money
Under certain circumstances, you may not need the money from an inherited IRA, or you may want to avoid being taxed.
IRA beneficiaries can choose to disclaim, or disclaim, the IRA and allow it to roll over to another beneficiary.
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