An inherited IRA may initially appear straightforward, or even like a financial opportunity. However, many beneficiaries are unaware that a significant tax burden can exist beneath the surface. Without a clear distribution plan, a portion of that inheritance may ultimately be lost to avoidable taxes. But beyond these strict rules and tax consequences, understanding how to approach inherited IRAs through thoughtful financial planning could help beneficiaries use these funds more efficiently. Our CEO and Senior Wealth Advisor, Marianela Collado, CPA/PFS, CFP®, CDS®, was recently quoted in TheStreet article, and shared her insights on how Inherited IRAs could be more complex than they seem.
What is an Inherited IRA? A Simplified Overview
An Inherited IRA is a retirement account given to a beneficiary after the passing of the original owner. It has different rules than a regular IRA, in that it cannot be treated as the beneficiary’s personal account or take contributions. Additionally, specific withdrawal rules must be followed, as the account will preserve the tax type chosen by the owner. With Traditional IRAs, withdrawals are taxed as ordinary income, but for a Roth IRA, withdrawals are generally tax-free but could still be subject to timing rules. Another aspect to be considered is the 10-Year Rule, which states that most non-spouse beneficiaries must withdraw all funds within 10 years. Withdrawing funds may not be required each year, but waiting towards the end of the 10-year period may result in eventual difficulties.
Inherited IRA Pitfalls: Deferring Distributions
Beneficiaries may delay withdrawals due to natural assumptions, like the idea that leaving the funds invested longer will result in more growth, or simply because the beneficiary wants to handle the account’s implications at a later time. These instincts are not incorrect, but could be an incomplete interpretation.
When withdrawals are delayed, the account balance may grow, but so does the potential tax burden. Since a large withdrawal in a single year typically gets added to overall income, this has the potential to push the beneficiary into a higher tax bracket, and results in a significantly higher tax bill.
The Tax Bracket Management Approach to Withdrawals
When it comes to Inherited IRAs, the goal isn’t just to withdraw funds, it’s to control how and when to recognize the income to potentially reduce the overall tax burden. “There might be room to fill up the lower brackets when income is temporarily lower,” Marianela shares. To put this into perspective, each year, income is taxed in layers, which are the brackets. If income is lower in a given year, there may be unused “space” in a lower bracket. Withdrawing just enough could potentially cause the beneficiary to stay in that lower bracket. This situation may be faced during early career years with lower income, temporary gaps in employment, or years with higher deductions or overall earnings. By spreading those withdrawals over time, likelihood of large tax spikes could be reduced, which may result in more predictable and manageable tax impacts.
Large withdrawals can interact with broader financial aspects in other ways. For example, these withdrawals may reduce eligibility for certain credits or deductions, impact financial aid calculations, or affect Medicare premiums later in life. Missing required distributions can lead to penalties, and though staying current on the rules may seem straightforward, they are constantly changing.
How a Financial Advisor Can Assist with Your Inherited IRA
An Inherited IRA comes with layered complexity. Proper planning could depend on the relationship with the original account holder, the type of account, the beneficiary’s income trajectory over the next 10 years, current and future tax laws, and more. Many beneficiaries may focus on the account itself and could potentially miss how it could fit into their overall tax picture. Small decisions may result in outsized, long-term effects.
Working with a financial advisor may shift the perspective from reactive to strategic thinking. Rather than thinking about when to withdraw the funds, thinking about how to withdraw them in the most tax-efficient way could help beneficiaries see the bigger picture. With a financial advisor, beneficiaries can build a multi-year withdrawal plan, identify lower income years to optimize distributions, and coordinate with an investment plan to help reach long-term financial goals. Thoughtful planning has the potential to significantly influence how much of an inheritance is ultimately preserved.
Turning Inherited IRA Complexity into Opportunities
Though Inherited IRAs may seem straightforward, careful planning can help improve their overall tax efficiency. Planning early could reduce the frantic withdrawals associated with waiting until the later years of the 10-year window. Large, last-minute withdrawals could largely affect a beneficiary’s overall tax burden, and engaging with a professional can help you consider how your Inherited IRA can fit into your overall financial plan.
If you’ve recently inherited an IRA or are curious about how this could affect your situation, we invite you to contact us. We’re here to hear your story and help you navigate uncertainty to reach your financial goals.
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