Millions of Americans could be caught out by new tax rules for inherited IRAs – here’s how to avoid a shocking bill
- Americans had more than $12 trillion in IRAs in the first quarter of the year
- Upon the death of an owner, the piggy banks pass to heirs
- But new rules imposed by the IRS make the process more complex — and families could face a hefty tax bill if they’re not careful
Changes in how inherited IRA accounts are taxed will sting millions of Americans starting next year, experts warn.
IRAs — also known as individual retirement accounts — are a popular tax-advantaged savings account. Households had more than $12 trillion in IRAs in the first quarter of 2023.
Over the past few years, the IRS has made a series of complicated changes to how these bills are levied once inherited, putting owners at risk of a hefty tax bill without proper advice.
Historically, when an owner passes away and hands it over, the heir has always had to pay a levy on any withdrawals. But the damage can be minimized by doing small withdrawals throughout their lives.
However, this tax-cutting strategy was ended by the Setting Every Community Up for Retirement Enhancement (SECURE) that went into effect in January 2020. Anyone who inherited an IRA before this date can still benefit from the old rules.
Changes in how inherited IRA accounts are taxed will sting millions of Americans starting next year, experts warn
The change meant heirs had two options: either take the money as a lump sum and pay taxes on that amount, or put the money in a special inheritance IRA.
It only applies to non-spouse heirs because spouses already have the option to treat inherited accounts as their own.
If they choose the latter, they must withdraw the full money within 10 years of the owner’s death, according to the rule change.
Financial planners and tax specialists assumed this meant that an heir could access the account at any time and then have to use it up within ten years.
However, a 2022 IRS ruling tore this strategy apart. The agency stated that if your parent died while drawing withdrawals from their IRA, the heir should continue from then until ten years after the death.
The IRS has waived fines for those not following the new rules, but that will change next year
All retirees are required to take “Minimum Requirement Benefits” out of their retirement pots once they reach age 73. This is an annual mandatory withdrawal from a tax-deferred account.
A tax-deferred account is when an owner is taxed at the time of withdrawal rather than when they make the contribution.
Ed Slott, founder of IRAHelptold Kiplinger that the new rules effectively mean that once a person starts taking RMDs, his heir will not be able to turn off this tap after his death.
Due to mass confusion surrounding these rules, the IRS waived penalties for heirs who failed to properly collect the RMDs from the decedent’s account in tax years 2021 and 2022.
In July, it extended this exemption through the 2023 tax year.
But from next year, heirs will be required to make distributions, with those who fail to comply facing fines worth 25 percent of the amount they should have withdrawn.
The fine is reduced to 10 percent if an heir compensates these missed contributions within two years.
It comes amid a spate of new IRS rules that make retirement and estate planning more complicated.
These include a change in how 401(K) catch-up contributions will squeeze those millions of high-earning Americans.
Likewise, officials quietly curbed a popular tax break on a certain type of estate tax that is often used to minimize estate taxes.