When you’re dealing with grief over the death of a spouse, the last thing that’s on your mind is tax law. Yet, the IRS allows only so much breathing room before taxes become an issue on an IRA you inherited from your spouse.
The hassle factor is blessedly limited if you’re named as the sole beneficiary of your betrothed’s IRA. The IRS treats the account (and any IRA-related taxes) as if it’s been your IRA all along. That means:
- You can continue to make contributions to the account up to the maximum the IRS allows based on your income. (That’s $6,000 a year in 2020, or $7,000 if you’re over age 50.)
- When you withdraw money from the account, the tax rules that apply to you will govern what, if anything, you owe Uncle Sam.
Those are the general IRA inheritance rules for spouses. And then there’s what’s written between the lines (or in the IRS tax code). That’s where you’ll learn about what to do to steer clear of an avoidable tax bill from Uncle Sam.
7 Key Moves to Keep Taxes on an Inherited IRA at Bay
The transfer of wealth is a tricky business. But you can avoid triggering a tax bill if you follow the rules. Here’s how to avoid some of the most notable things that trip up heirs:
1. Don’t mix and match IRA types
There are many types of IRAs, but the two main ones are Roth and traditional. (Here’s how they compare.) If your beloved left you investments in a Roth IRA, make sure you move the money into an existing Roth IRA you already have or open a new Roth IRA. Same deal if you inherit a traditional IRA.
>> RELATED: How to Open an IRA
A word for non-spouses or spouses who inherited an IRA with other beneficiaries: Transfers into existing IRAs are not allowed, nor are additional contributions. You’ll have to set up a new IRA to transfer the portion of money you inherited.
2. Avoid the 10% early withdrawal penalty
With a Roth IRA you’re allowed to withdraw contributions to the account at any time completely tax- and penalty-free. As a spouse, the same rule applies to you within the inherited Roth. Tread lightly with earnings, though. (We’ll explain more about the stopwatch you need to heed next.) With a few exceptions, generally you must be age 59 ½ or older to withdraw Roth IRA earnings to avoid the IRS’s 10% early withdrawal penalty. Traditional IRAs account holders must wait until age 59 ½ to withdraw contributions or earnings to avoid the 10% ding.
Special note: Under CARES Act rules, the IRS is waiving the 10% early withdrawal penalty on any coronavirus-related distributions. It is also allowing account holders to spread out income taxes over a three-year period.
3. Heed the 5-year earnings rule
As we mentioned above, you’re allowed to cash out Roth IRA contributions at any time and at any age. But with earnings there are two things to know: 1. In most cases you have to wait until age 59 ½ to withdraw earnings without paying a 10% penalty. 2. Earnings are also subject to a 5-year rule. That means the account must be open for at least five years before you can make tax-free withdrawals. The 5-year clock on an inherited IRA starts when the original owner opened the account.
4. Take out some money at age 72
Another important date to mark on your calendar is the year you turn 72. That’s when you’re required to start taking required minimum distributions (RMDs) from a traditional IRA — both your own and any tax-deferred account you inherited from your spouse. (See more about IRA withdrawal rules from the IRS right here.)
The CARES Act gives account holders a temporary reprieve from RMDs, at least for the rest of 2020. This allows you to keep the assets in a traditional IRA — even an inherited one — and push off the income tax bill at least until 2021
5. Note the new 10-year rule if you’re not the sole beneficiary
The SECURE Act, passed at the end of last year, changed some of the IRA inheritance rules. (This applies to spouses who are not the sole IRA beneficiary.) In a nutshell, some IRA beneficiaries are required to empty the inherited account within 10 years of the original owner’s death. Fidelity has a good explainer on how the SECURE Act affects inherited IRAs.
6. Be strategic with lump sum distributions
If you decide to withdraw a big chunk of money from an inherited IRA, beware. Distributions from a traditional IRA will be taxed as income in the year you take out the money. Adding a big balance to one year’s income can push you into a higher tax bracket.
For many people, it makes sense to spread out the tax burden by taking distributions over a number of years. Look at your current income situation — or meet with a financial pro — before you cash out.
7. Avoid this 50% penalty at all costs
This is a good rule to heed for everyone, not just spouses who inherit an IRA. The IRS is serious about enforcing RMDs. In pre-pandemic times blowing off RMD requirements would buy you a 50% penalty tax on the amount you should have withdrawn. If you’re eligible for the temporary RMD waiver, you’ll get a break this year. But keep an eye on tax laws so you’re not inadvertently forced to give the IRS a chunk of money your loved one left for you to use.
Because IRA inheritance rules can get really tricky really quickly, it’s a good idea to consult with a financial professional about your options. If you don’t have one already, fill out this two-minute questionnaire we created in partnership with Wealthramp. Based on your answers, you’ll be given a list of fee-only fiduciary advisors that you can contact when you’re ready.
More about IRAs and estate planning on HerMoney:
- IRA Inheritance Rules in 600 Words or Less
- IRA vs. 401(k): What’s the Difference?
- When Death Happens: Planning for the Unexpected
JOIN THE CLUB: Own your money, own your life. Subscribe to HerMoney today for inspiration, advice, insights and more!