How Do I Avoid Paying Taxes on an Inherited IRA?

The standard tax rules on individual retirement accounts (IRAs) change when you’re dealing with inherited IRAs. Some differences are positive. For instance, someone who inherits an IRA doesn’t pay a penalty for early withdrawal before age 59 ½. On the negative side, special rules for inherited IRAs may force beneficiaries to take the money out sooner than they’d like. That can trigger an unwanted income tax obligation and even increase taxes on other income by pushing the beneficiary into a higher tax bracket. Fortunately, there are ways to avoid or reduce the potential tax bite on an inherited IRA. A financial advisor may be able to help walk you through your options.

What Is an IRA?

A traditional IRA lets you make tax-deductible contributions to your own retirement savings plan. In addition, earnings from investments made with funds in an IRA grow tax-free. You don’t pay taxes on either contributions or earnings until you start making withdrawals later on after retiring.

A Roth IRA is a retirement savings vehicle that you fund with after-tax dollars. Roth IRA contributions don’t get you a current tax deduction. But earnings on funds in a Roth IRA also grow tax-free and, unlike a traditional IRA, you don’t owe income taxes on qualified withdrawals once you start taking money out in retirement.

Cashing Out an Inherited IRA

An inherited IRA, also known as a beneficiary IRA, is either a traditional or Roth IRA that has been left to you by someone who has died. For most individuals, you can cash out an inherited IRA or withdraw at any time. You generally have 10 years from the death of the original owner to cash out all of the assets within the inherited IRA.

However, there may be some tax consequences of cashing out an inherited IRA that you’ll want to plan for before you start making withdrawals. Depending on whether you are inheriting a traditional or Roth IRA, the tax consequences could be very different.

Tax Consequences of Inheriting a Traditional IRA

The key point about inheriting a traditional IRA is that any money you take out is taxed as regular income. If the amount is large, it could push you into a higher tax bracket, meaning you’ll pay more in taxes on that withdrawal.

Inherited IRAs do qualify for some special treatment, however. For instance, while withdrawals taken by the original account owner before age 59 ½ are ordinarily subject to a 10% penalty, a beneficiary doesn’t have to pay that penalty even when withdrawing at a younger age.

Beyond that, much depends on just who bequeathed you the IRA. If you inherit a traditional IRA from your spouse, you can treat it as your own. This means that you don’t have to take required minimum distributions (RMDs) until you turn 73—or 75 if you were born in 1960 or later. But if you inherit the IRA from someone else, different rules apply.

Most non-spouse beneficiaries must follow the 10-year rule, which means the entire account must be emptied by the end of the 10th year after the original owner’s death. All withdrawals are taxable as income, and large withdrawals could push you into a higher tax bracket.

Tax Consequences of Inheriting a Roth IRA

A husband and wife reviewing if they can avoid taxes on an inherited ira.

Funds withdrawn from an inherited Roth IRA are generally tax-free if they are considered qualified distributions. That means the funds have been in the account for at least five years, including the time the original owner of the account was alive. If they don’t meet the qualified distribution criteria, funds withdrawn from an inherited Roth IRA are taxed as ordinary income.

Once again, the relationship between the beneficiary and the original owner makes a difference. A Roth IRA inherited from a spouse can be treated as the beneficiary’s account. This means the new owner can take tax-free withdrawals at his or her option once the five-year rule has been met.

If the Roth IRA came from anyone else, however, the beneficiary has to take RMDs just as if it were a traditional IRA. That means withdrawing the full amount within 10 years. Also, the same exceptions for disabled, chronically ill and underage beneficiaries apply.

Tax Planning Strategies for Inherited IRAs

One inherited IRA tax management tip is to avoid immediately withdrawing a single lump sum from the IRA. Instead, wait until RMDs are due, or, if you got the IRA from a non-spouse, stretch withdrawals over 10 years.

RMDs are taxable and can change your tax bracket and increase your overall tax burden. But if, as is often the case, you are in a lower tax bracket when you have to start taking them, you may be able to save on taxes by deferring withdrawals until the RMD rules force you to start.

If you have to empty the account in 10 years, you don’t have to withdraw equal annual amounts. You can instead wait until your income is lower than normal, then take a larger withdrawal from the inherited IRA. Similarly, if your income is higher in another year, you can take less that year, as long as the entire amount is withdrawn after 10 years. This income-leveling strategy can result in a lower overall tax outlay.

Then again, if you inherited the account from a non-spouse who already started taking RMDs, you’ll need to continue taking those RMDs.

If you inherited a Roth IRA with funds deposited less than five years ago, one strategy is to wait before taking those funds out. When the five-year period has elapsed, withdrawals will be treated as tax-free qualified distributions.

On the flip side, if you want to bequeath your IRA account to a beneficiary, you will have to complete this tax-management strategy before you die. As the account holder, you can convert a traditional IRA to a Roth IRA, thereby paying any taxes due on contributions and earnings.

This tax planning move can also be a smart estate planning move, as it can help reduce overall taxes on the funds that your beneficiaries will inherit, especially if they are in a higher tax bracket than you. Additionally, a Roth IRA conversion would then allow your beneficiary to withdraw the funds later on without incurring income taxes.

Inherited IRAs: Exceptions to the Rule

If you inherited the IRA from someone other than a spouse, you can’t wait for your own RMDs to start. Instead, you have just 10 years from the time you inherited the account to withdraw and pay taxes on the entire amount. Exceptions apply if you are disabled, chronically ill or an underaged child (but the ten-year rule kicks in this last case when they turn 21). Another exception applies if you are less than 10 years younger than the original owner of the IRA.

Bottom Line

A man discussing how to avoid taxes on an inherited ira with his advisor.

A person who inherits an IRA can expose themselves to significant tax consequences if they simply withdraw the money from the account in a single lump sum. By stretching withdrawals out over the years, on the other hand, they can keep taxes as low as possible while still benefiting from the inheritance. It’s important to find the right choice based on your unique circumstances.

Tips on Saving for Retirement

If you anticipate inheriting or bequeathing an IRA, you may want to consider working with a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’re planning for retirement on your own, it pays to be in the know. SmartAsset has you covered with tons of free online resources to help. For example, check out SmartAsset’s retirement calculator and get started today.