The Tax Problem That Can Surface in an Inherited IRA

Inheriting money is usually a plus for your finances, helping with expenses and boosting savings. But when the inheritance is a traditional individual retirement account (IRA), there are tax rules you need to understand before deciding how to take withdrawals.

Here’s a look at inherited IRAs and the ways they can affect your tax bill.

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Why the tax issue matters

The IRS generally requires non-spouse beneficiaries to empty the account within 10 years. In some cases, they may also need to take required minimum distributions, or RMDs. These are withdrawals that the IRS mandates from certain tax-deferred retirement accounts beginning at age 73, and for some beneficiaries depending on factors such as whether the original owner had already started taking them.

Because withdrawals from traditional IRAs are taxed as ordinary income, pulling money out can raise your taxable income and potentially move you into a higher tax bracket. You will also owe taxes on the distributions themselves.

That can be especially frustrating for people who are still working full time and earning at a relatively high level, since higher income often already places them in a higher bracket.

Who faces the biggest risk

Someone in their 50s who inherits a parent’s IRA is often still employed and may have to deal with higher tax rates on traditional IRA withdrawals. A surviving spouse usually has more flexibility than other beneficiaries. Depending on the circumstances, they may be able to roll the assets into their own IRA or postpone withdrawals.

These distributions can also affect other parts of your finances. They raise your modified adjusted gross income, which can lead to higher Medicare Part B and Part D premiums. And if you are taking Social Security at the same time, the higher income can increase the portion of those benefits that is taxed, since as much as 85% of Social Security can be taxable.

Ways to reduce the tax burden

If you inherit a Roth IRA, withdrawals are generally tax-free. You may still be required to withdraw the money within 10 years.

With a traditional IRA, though, timing matters. One approach is to withdraw money gradually over the 10-year period so the tax hit is spread out rather than concentrated in the final year. Another option is to take more money in years when your income is lower or when you have more deductions.

There are several ways to lessen the overall tax cost, and it can be wise to speak with a tax professional to decide what fits your situation best.