How to Reduce Taxes on Your Inherited Individual Retirement Account

Inherited individual retirement accounts can be a financial benefit to heirs, but the windfall can trigger tax problems, experts say.

Pre-tax withdrawals from inherited IRAs incur regular income taxes. As of 2020, some heirs can no longer “stretch” retirement account distributions over their lifetime to reduce annual taxes.

Now, some heirs, including most adult children, must exhaust inherited accounts within 10 years, known as the “10-year rule.” The rule applies to heirs who are not a spouse, a minor child, a disabled person or a chronically ill person. This may also apply to certain trusts.

Ideally, you should smooth out your annual tax liability “so you don’t get crushed at the end of the tenth year,” said Ed Slott, an individual retirement account expert and CPA.

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The IRS proposed mandatory annual withdrawals from inherited IRAs in 2022 if the original account owner had already started distributions. However, the IRS waived the penalty for missed required minimum distributions amid confusion – and extended that relief for 2024 in April.

Slott said there is widespread confusion about the rules, but the relief only condenses the 10-year window for taxable IRA withdrawals.

“They’re just postponing the inevitable,” said JoAnn May, a Berwyn, Ill.-based certified financial planner with Forest Asset Management. She is also a chartered accountant.

Although only about 20 percent of May’s clients inherited an IRA, she expects more heirs will face the issue of tax planning as baby boomers age.

Larger inherited IRA withdrawals can significantly increase adjusted gross income, which can have “unintended consequences” such as higher Medicare Part B and Part D premiums for retirees, May explained.

Younger heirs could also be affected by higher incomes. They might face college funding issues when submitting the Free Application for Federal Student Aid, or FAFSA.

Additionally, there are income phaseouts for Roth IRA contributions, as well as tax breaks such as the child tax credit, student loan interest deduction and more.

Typically, May does multi-year projections to help clients decide the best years to make withdrawals from inherited IRAs.

“Tax planning is very important,” she said.

Advisors can take advantage of a year of low income – such as after a job loss, retirement or other life changes that affect income – to obtain more income and reduce future withdrawals.

Typically, they try to earn enough income to fill one tax bracket without carrying over into the next one with a higher rate.

There are also tax planning opportunities for the original IRA owner, CFP Karl Schwartz, principal and senior financial advisor at Team Hewins in Boca Raton, Florida, previously told CNBC.

For example, the original owner may consider so-called Roth IRA conversions. This decision triggers an initial tax and after the conversation, the balance grows tax-free. Heirs would still be subject to the 10-year rule, but withdrawals would not result in levies.

“It would probably make sense if they were in a lower tax bracket than their beneficiaries,” Schwartz said.