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Navigating the Tax Burden for Inherited IRAs

Updated: Nov 9, 2021

In 2019 new federal rules for individual retirement accounts were phased in that increase the tax burden for some heirs by reducing the period for withdrawing funds from inherited accounts. It is possible to navigate through this potential tax pitfall by converting regular IRAs to Roth IRAs before bequeathing them.

Before these new rules took effect, someone who received an inherited IRA had their entire life expectancy to withdraw from it. Withdrawals could be stretched over decades – which is why some called them stretch IRAs. And any withdrawals would be treated as ordinary income in terms of taxes.

When Congress passed the Secure Act of 2019, they changed the rules for who can stretch these withdrawals. Surviving spouses, minor children and the chronically ill, maintain the lifelong stretch period.

But all other heirs, including adult children, must draw down funds in the account within 10 years. And those withdrawals are still treated as ordinary income. Suppose you plan to bequeath an IRA account to your adult child. Those required withdrawals will boost their income, potentially leaving a significant tax burden.

Ultimately that means more of your accumulated wealth goes to Uncle Sam instead of your family. It might be a good time to think through estate-planning strategies to address this. Before these new rules, leaving heirs an IRA meant passing along some of your lifetime income tax liability, due to the tax-deferred nature of these accounts. And the stretch rules allowed your heirs the rest of their lives to pay these taxes while they could continue investment gains and minimize this tax burden by spreading it out over many years.

Now, this inherited wealth could come with a much greater tax burden for your heirs which they would feel almost immediately. Most will likely withdraw one-tenth of the IRA’s assets every year for 10 years to spread out the tax impact.

Let’s break this down in concrete terms. Suppose an individual with an annual household income of $100,000 inherits an IRA with $500,000 in assets. If the account holds its value and they withdraw 10% each year, these withdrawals would boost their gross income by 50% each year — and could very well push them into a much higher bracket. Before the new rules, heirs could stretch withdrawals until maybe they stop working and enter a lower tax bracket.

One solution is to convert a regular IRA into a Roth IRA. Unlike regular IRAs, which are funded with pretax income, contributions to Roth IRAs are made solely with post-tax money. Roth IRAs also must be depleted within 10 years of receiving the inheritance, but what a difference that these withdrawals create no tax burden.

For a long time people have been aware that in leaving an IRA, they are also passing on the responsibility of paying tax on the investment income. That seemed a good exchange back when rules permitted the option to stretch those withdrawals. But now that the stretch option has changed, it can become a much greater burden – and one that takes a much bigger tax bite out of the assets you’ve been building.

Bottom line: it might make sense to convert your IRA to a Roth conversion. Now such a conversion is a form of withdrawal, which can create significant tax liability in the year the assets are converted. It becomes a question of paying the tax now or paying it later. And that’s where the particulars of your situation need to be considered. However, many account holders don’t realize they can spread out this tax impact by moving IRA assets into a Roth gradually over multiple years. Best to talk with your tax professional to assess your particular situation.

As you move closer to retirement, converting to a Roth has other advantages. Regular IRAs have required minimum distributions that begin at age 72 (under the old rules, this age was 70½). But if you continue working or retire with enough income from other resources, you can avoid those withdrawals and grow the assets in your account.

Brixton Capital Wealth Advisors does not provide tax advice, so contact a tax professional about your particular circumstances. But we are always available to talk if you want to learn more about converting your regular IRA. It well might reduce your heirs’ tax burden and grow your assets at the same time.

Other ways you might reduce taxes on Roth conversions:

• Convert after you retire and are in a lower income-tax bracket.

• Convert all or most assets in a year when you have low taxable income, when your effective tax rate is lower than usual. Small business owners might consider doing this during a year of low profits.

• Create a donor-advised fund for charitable giving. Donations to specific charities can be made later but funding this through IRA disbursements can result in a significant deduction. And used in combination with the Roth conversion can offset tax liabilities that same year. • Convert in a year when extremely high health-care expense reduce your taxable income. Those with high uncovered medical expenses could use those deductions to offset the tax impact of a Roth conversion.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, Its accuracy, completeness or reliability cannot be guaranteed. 

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