Unless you spend your winters in Aspen and your summers in the Hamptons, you probably don’t have to worry about paying federal estate taxes on an inheritance. In 2021, the federal estate tax doesn’t kick in unless an estate exceeds $11.7 million. The Biden administration has proposed lowering the exemption, but even that proposal wouldn’t affect estates valued at less than about $6 million. (Some states have lower thresholds, however.)
But if you inherit an IRA from a parent, taxes on mandatory withdrawals could leave you with a smaller legacy than you expected. And as IRAs become an increasingly significant retirement savings tool—Americans held more than $13 trillion in IRAs in the second quarter of 2021—there’s a good chance you’ll inherit at least one account.
How the SECURE Act Changed Things
Before 2020, beneficiaries of inherited IRAs (or other tax-deferred accounts, such as 401(k) plans) could transfer the money into an account known as an inherited (or “stretch”) IRA and take withdrawals over their life expectancy. This enabled them to minimize withdrawals, which are taxed at ordinary income tax rates, and allow the untapped funds to grow.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 put an end to that tax-saving strategy. Now, most adult children and other non-spouse heirs who inherit an IRA on or after January 1, 2020, have just two options: Take a lump sum or transfer the money to an inherited IRA that must be depleted within 10 years after the death of the original owner.
The 10-year rule doesn’t apply to surviving spouses. They can roll the money into their own IRA and allow the account to grow, tax-deferred, until they must take required minimum distributions, which start at age 72. (If the IRA is a Roth, they don’t have to take RMDs.) Alternatively, spouses can transfer the money into an inherited IRA and take distributions based on their life expectancy. The SECURE Act also created exceptions for non-spouse beneficiaries who are minors, disabled or chronically ill, or less than 10 years younger than the original IRA owner.
But IRA beneficiaries who aren’t eligible for these exceptions could end up with a hefty tax bill, especially if the 10-year withdrawal period coincides with years in which they have a lot of other taxable income.
The 10-year rule also applies to inherited Roth IRAs, but with an important difference. While you must still deplete the account in 10 years, the distributions are tax-free, as long as the Roth was funded at least five years before the original owner died. If you don’t need the money, waiting to take distributions until you’re required to empty the account will provide you with up to 10 …….
Source: https://www.kiplinger.com/retirement/estate-planning/603650/minimizing-taxes-when-you-inherit-money