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If you inherited a pre-tax individual retirement account in 2020 or later, you could be facing a big tax bill if you don't plan properly, experts say.
Previously, heirs were able to withdraw money from inherited IRAs throughout their lifetimes, known as “stretch IRAs.”
However, the SECURE Act of 2019 created the “10-year rule,” requiring certain heirs, including adult children, to spend down an inherited IRA within 10 years of the original account owner's death.
But waiting until the 10th year to withdraw money from an IRA “could leave you sitting on a tax bomb,” said Ben Smith, a certified financial planner and founder of Cove Financial Planning in Milwaukee.
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Pre-tax IRA withdrawals are subject to ordinary income tax, and the 10-year rule may mean higher annual taxes for certain heirs, especially for high-income earners with large IRA balances.
Shortening the 10-year withdrawal period could further complicate the issue, experts say.
Smith said larger withdrawals could significantly increase adjusted gross income and result in higher capital gains tax rates and the phase-out of other tax benefits.
For example, Smith has seen people lose eligibility for the electric vehicle tax credit, worth up to $7,500, because they made large withdrawals from inherited IRAs in one year.
Required Withdrawals from Inherited IRAs
Since 2019, there has been confusion about whether certain heirs are required to make annual withdrawals. You'll need to take required minimum distributions, or RMDs, during the 10-year period.
After years of waiving penalties, the IRS finalized its RMD rules for inherited IRAs in July.
Starting in 2025, certain beneficiaries (spouse, minor children, disabled or chronically ill individuals, or certain non-trust heirs) must take an RMD annually from an inherited IRA. The RMD rules apply if the original account owner reached the RMD age, or “required beginning date,” before their death.
Starting in 2020, the Secure Act raised the RMD start age from 70 1/2 to 72. However, Secure 2.0 implemented two increases: starting in 2023, the RMD start age is 73, and starting in 2033, it is 75.
Withdrawing your IRA is a “Timing Issue”
Even if RMDs aren't required, experts say heirs should consider spreading out withdrawals from inherited IRAs.
“If you don't take a distribution from an inherited IRA in a year and the amount continues to grow, your taxes will grow accordingly,” says Carl Holbowich, CFP, a principal at Armstrong, Fleming & Moore in Washington, D.C. “You'll eventually be taxed on that money. It's just a matter of timing.”
If you don't take a distribution from an inherited IRA in a year and the IRA continues to grow, your taxes will increase accordingly.
Carl Holbowich
Principal at Armstrong, Fleming & Moore
Experts say some heirs may want to take larger withdrawals from inherited IRAs during the 10-year grace period in years with lower incomes, or consider other tax-saving strategies.
Future income tax brackets
Ed Slott, a CPA and IRA expert, previously told CNBC that individuals might also consider their future federal income tax bracket.
Without Congressional changes, dozens of individual tax provisions, e.g. The measures lowering the federal income tax brackets will be phased out after 2025. The rates will revert to 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.
“If you don't use it every year [the lower brackets] “It's a wasted opportunity,” Slott said.
However, with control of the White House and Congress uncertain, it is difficult to predict whether federal tax rates will change after 2025.
