The Inheritance Challenge
Kiplinger's Personal Finance|December 2021
Some inherited assets are tax-friendly, but under new rules, others come with a hefty tax bill. We help you get the most out of a legacy.
SANDRA BLOCK

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; see the box on page 58.)

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.

NEW RULES

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 nonspouse 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 years of tax-free growth, says Victor Schultz, president and chief fiduciary officer at Prairie Trust, a wealth management firm in Brookfield, Wis.

PLANNING WITHDRAWALS

Many heirs simply cash out their parents’ IRAs, but if you take a lump sum from a traditional IRA, you’ll owe taxes on the entire amount. Depending on the size of the account, that could kick you into a higher tax bracket.

Transferring the money to an inherited IRA will allow you to spread out the tax bill, albeit for a shorter period than the law previously allowed. Taking an annual distribution of one-tenth of the amount of the IRA, for example, would probably minimize the impact on your tax bill. But because the new rules don’t require annual distributions, you have some flexibility. If you’re planning to retire in a couple of years and expect your tax bracket to drop, for example, it may make sense to postpone taking withdrawals until you stop working, says Howard Hook, a certified financial planner with EKS Associates, in Princeton, N.J. Still another option is to wait until year 10 to withdraw the money, which would give you a decade of tax-deferred growth. On the downside, withdrawing all of the money at once could trigger a bracket-breaking tax bill.

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