Minimize taxes when you inherit money

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Unless you spend your winters in Aspen and your summers in the Hamptons, you probably don’t have to worry about paying federal property taxes on an inheritance. In 2021, federal inheritance tax only comes into effect if an estate exceeds $ 11.7 million. The Biden administration has proposed lowering the exemption, but even that proposal would not affect estates valued at less than around $ 6 million. (Some states have lower thresholds, however.)

But if you inherit an IRA from a parent, taxes on mandatory withdrawals could leave you with a smaller inheritance than you expected. And as IRAs become an increasingly important retirement savings tool – Americans held over $ 13 trillion in IRAs in the second quarter of 2021 – there’s a good chance you’ll inherit at least one. account.

How the SECURE law changed things

Prior to 2020, beneficiaries of legacy IRAs (or other tax-deferred accounts, such as 401 (k) plans) could transfer the money to an account known as a legacy IRA (or “stretch”) and make withdrawals during their lifespan. This has allowed them to minimize withdrawals, which are taxed at the ordinary income tax rate, and allow untapped funds to grow.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 ended this tax saving strategy. Now, most adult children and other unmarried heirs who inherit an IRA on or after January 1, 2020, have only two options: take a lump sum or transfer the money to an inherited IRA that must be depleted within. 10 years after death. from the original owner.

The 10-year rule does not apply to surviving spouses. They can transfer the money to their own IRA and allow the account to grow, tax-deferred, until they have to receive the minimum required distributions, which begin at age 72. (If the IRA is a Roth, they don’t have to take an RMD.) Alternatively, spouses can transfer the money to an inherited IRA and receive distributions based on their life expectancy. The SECURE Act also created exceptions for unmarried beneficiaries who are minors, disabled or chronically ill, or less than 10 years younger than the original owner of the IRA.

But IRA recipients who are not 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 one important difference. Although you must still exhaust the account in 10 years, distributions are tax-free, as long as the Roth was funded at least five years before the death of the original owner. If you don’t need the money, waiting to receive distributions until you are forced to empty the account will give you up to 10 years of tax-free growth, says Victor Schultz, President and Trustee of Prairie Trust, a wealth management company in Brookfield, Wisconsin.

Don’t rush to cash out an inherited IRA

Many heirs simply cash out their parents’ IRA, but if you take a lump sum from a traditional IRA, you will owe taxes on the full amount. Depending on the size of the account, this could put you in a higher tax bracket.

Transferring the money to an inherited IRA will allow you to spread the tax bill, albeit for a shorter period than the law previously allowed. Taking an annual distribution of one-tenth of the IRA amount, for example, would likely minimize the impact on your tax bill. But since the new rules don’t require annual distributions, you have some flexibility. If you’re planning to retire in a few years and expect your tax bracket to drop, for example, it may be a good idea to defer withdrawals until you stop working, explains Howard Hook, Certified Financial Planner with EKS Associates, Princeton. , NJ Yet another option is to wait until year 10 to withdraw the money, which would give you a decade of tax-deferred growth. On the other hand, withdrawing all the money at once could trigger an out-of-range tax bill.

If you choose to transfer the money to a Legacy IRA, make sure that the funds are transferred directly to your account. If you take the money in the form of a check, the full amount will be treated as a taxable distribution. And regardless of how your withdrawals are broken down, be sure to empty your account by December 31 of the 10th year following the year the original IRA owner died to avoid a draconian penalty of 50% of the amount. that you should have removed.

How does the progression base help

Fortunately, most of the other inherited assets are much less onerous, at least when it comes to the IRS. In fact, you might owe little or no tax on real estate, bank accounts, and investments that are not held in tax-deferred accounts. In effect, the base price of these assets is “raised” to their value on the day of the death of the original owner.

Suppose your father paid $ 50 for a stock and it was worth $ 250 on the day he died; your base would be $ 250. If you sell the stock immediately, you won’t owe any taxes, but if you keep it, you’ll only have to pay taxes (or be able to claim a loss) on the difference between $ 250 and the sale price. President Biden has proposed eliminating the increase for earnings over $ 1 million ($ 2 million for a married couple), but the outlook for this plan is unclear. Previous efforts to curb the ramp-up have been unsuccessful, in part because of the potential difficulties heirs would face in determining the basis of stocks and other assets purchased many years ago.

The increase also applies to the value of your family home (and any other property you inherit), a big plus at a time when many older homeowners have seen their home’s value skyrocket.

If you decide to keep investments or inherited property, you will owe taxes on the difference between the value of the assets on the day of the original owner’s death and the day of the sale. If a stock or inherited fund is right for your long-term investment strategy, you might want to keep it, says Crystal Cox, CFP at Wealthspire Advisors in Madison, Wisconsin. Otherwise, you are probably better off selling and investing the product in investments that suit your risk tolerance and your portfolio allocation.

Figuring out what to do with an inherited home is more complicated. Unless you decide to keep the house, which may mean buying back other heirs, you will have to sell it, which could take months. In the meantime, be sure to pay property taxes, insurance premiums, and other costs associated with maintaining the home. This task usually falls to the executor. (See What to do when you are the executor for more details.)

How to reduce taxes for your heirs

If you have a traditional IRA (or other tax-deferred account), there are steps you can take to reduce the tax burden on your heirs.

Think about your beneficiaries. The SECURE Act’s 10-year rule for Inherited IRAs has several exceptions. In addition to spouses, other heirs may still spread withdrawals over their lifetime, including minor children, beneficiaries who are ill or chronically disabled, and heirs who are less than 10 years younger than you. You may want to name these people as beneficiaries of your IRA and leave other types of assets to the heirs who would be subject to the 10-year rule.

If that’s not an option, consider the financial situation of your beneficiaries. You may want to bequeath your IRA to an adult child who is in a low tax bracket, for example, and donate other assets to a child who earns six-figure income.

Convert some funds from your traditional IRA to a Roth. Although the Roths are also subject to the 10-year rule, distributions are not taxed. This is a huge bonus for your heirs, but you have to pay taxes on any funds you convert.

Before converting funds, compare your tax rate with those of your heirs. If your tax rate is much lower, it may be a good idea to convert some of your IRA funds to Roth. The math is less compelling if your heirs’ tax rate is lower than yours, especially if a conversion could propel you into a higher tax bracket.

Also be aware that a large Roth conversion could result in higher Medicare premiums and taxes on your Social Security benefits.


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