Editor’s Note: This story originally appeared on Boldin.
When you inherit an IRA, it’s more than just a financial windfall; it’s also a responsibility.
The rules governing inherited IRAs are complex and can significantly impact how much you’ll ultimately receive after taxes, as well as how you manage your finances long-term.
Whether you’re navigating Secure Act regulations, balancing tax considerations, or planning for your own retirement goals, having a thoughtful withdrawal strategy is essential.
Keep reading for the key 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.
Rules for your inherited IRA distributions
The rules for distributions on inherited IRAs depend on several factors, including:
- Your relationship to the original account owner
- Whether it’s a Roth or traditional IRA
- Whether your benefactor passed before or after 2020 (due to changes introduced by the Secure Act)
- Whether the original account owner had already started taking required minimum distributions (RMDs) or not
When you model your inherited IRA in the Boldin Retirement Planner, you will see the distribution rules that must be applied 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 might sound like the highway to tax-deferred growth, delaying distributions until the 10th year has the potential to push you into higher tax brackets and increase your tax bill.
Avoid penalties on your inherited IRA
You will want to follow the distribution requirements that are applicable to your account.
Failure to do so can result in significant penalties (usually 25% of the missed distribution amount).
Options for the required distributions on your inherited IRA
You do have a few options for making the required withdrawals. Consider these criteria:
Tax implications: This is a big consideration. Required withdrawals from an inherited IRA can push you into a higher tax bracket. Read on for more about minimizing taxes on distributions from an inherited IRA.
Your financial goals: If taxes are not a concern, you may be able to withdraw funds to optimize for your financial goals. Do you need immediate income? Or can you let the account grow?
Align your withdrawals with specific objectives such as paying off debt, funding retirement, or covering major expenses.
Options for minimizing taxes on inherited IRA distributions
Within the distribution rules for inherited IRAs, you may have options. You may be able to withdraw the money in different amounts and over different time periods. And the decisions you make about your distributions will have a big impact on taxes.
If you distribute the entire IRA in the first year or delay distributions until the 10th year, you may be pushed into a higher tax bracket for that year as well as incur additional negative ripple effects.
Looking for ways to spread inherited IRA distributions over the 10-year period can help you manage income taxes by taking advantage of lower tax brackets.
And smart distribution strategies can potentially reduce the total income tax liability of the inherited IRA.
Strategies to consider
Space out distributions:
- One strategy to consider is spacing out distributions over the 10-year period. This allows you to to benefit from tax-deferred appreciation while also managing taxes.
Fill up lower brackets:
- You may want to explore using taxable distributions to “fill up” a marginal tax bracket each year but avoid moving into the next, higher, bracket.
Look for low tax years:
- Waiting until you retire to take distributions may lower your overall tax bill.
Offset the tax implications:
- You might be able to offset the additional taxes of inherited IRA withdrawals by increasing contributions to your own retirement accounts. Maxing out your own retirement contributions can help keep the tax impact of inherited IRA distributions to a minimum.
- Another potential strategy to offset the tax impact of inherited IRA withdrawals is by increasing contributions to charitable organizations and/or a donor-advised fund.
When to customize your approach to inherited IRA withdrawals
If any of the following circumstances apply to you, you may need a more customized approach to manage the impact of inherited IRA distributions.
Meeting MAGI requirements
If you need to meet MAGI (modified adjusted gross income) requirements for any of the following, you’ll want to assess the impact of inherited IRA distributions on your MAGI and create a strategy which enables you to meet your distribution requirements while staying below the desired MAGI.
Tax deductions:
- Student loan interest deduction
Tax credits:
- Education-related tax credits — the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC)
- Premium Tax Credits (PTC) that may lower monthly premiums when you buy health insurance through the marketplace
- Child Tax Credit (CTC)
- Earned Income Tax Credit
- Saver’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 or will turn 63 during the 10-year period, inherited IRA distributions may raise your adjusted gross income (AGI) above the income-related monthly adjustment amount (IRMAA) thresholds and increase your Medicare costs.
Your Social Security benefits
If you are receiving Social Security benefits, the percentage of Social Security benefits subject to tax is determined, in part, by your AGI.
If you don’t need the money
Under certain circumstances, you may not need the money from an inherited IRA, or you may want to avoid the tax hit.
IRA beneficiaries can choose to disclaim, or not accept, the IRA and allow it to pass it to another beneficiary.
