Why Inheriting an IRA Can Come with a Tax Surprise

When you hear that the first $13 million of an estate is tax-free, you might assume that inheriting assets like an IRA comes with no tax implications. Unfortunately, that’s not always the case. While estate taxes won’t kick in unless the estate is very large (over $13 million in 2024), there’s a different kind of tax that can affect the assets you inherit—especially IRAs.

Time to think about the tax implications of inheriting an IRA. Make sure you’re prepared!

The Estate Tax vs. Income Tax

The estate tax, which only applies to very large estates, is often what people think of when they hear about taxes on inheritances. But what many don’t realize is that when you inherit an IRA, you may have to pay income tax on it.

An IRA, or Individual Retirement Account, is funded with pre-tax money, meaning the person who set it up didn’t pay taxes on the money when it went in. As the new owner of the IRA, when you withdraw money from it, it’s treated as ordinary income, and you’ll likely need to pay income tax on those withdrawals. Depending on your tax bracket, this could significantly reduce how much you actually get to keep from the IRA.

How It Works

Say you inherit a $100,000 IRA. If you decide to withdraw $20,000 this year, that $20,000 would be added to your taxable income for the year, possibly pushing you into a higher tax bracket. This could mean a bigger tax bill than you expected. While the overall estate may have been under the $13 million limit for estate tax, you still need to account for the taxes due when you take money out of the inherited IRA.

Important Changes to IRA Rules

In the past, beneficiaries could spread these withdrawals over their lifetime, making it easier to manage the tax hit. However, recent changes to the law now require many beneficiaries to empty the account within 10 years of inheriting it. This can create a need for smart tax planning to avoid being hit with large tax bills.

The Bottom Line

If you’re in line to inherit an IRA, it’s important to understand the potential tax impact. While the estate itself may not owe taxes, you could still face income tax when you start withdrawing from the IRA. It’s always a good idea to talk to a financial advisor or your CPA to plan how best to manage the taxes and make the most of your inheritance.

Are you comfortable with your progress towards retirement? How about helping future generations meet their financial goals? If you have more than $2 million saved and need help from a wealth manager, the Peak Wealth Planning team can assist. 

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About the Author

Peter Newman is a Chartered Financial Advisor (CFA®) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.

Peak Wealth Planning offers personalized concierge services to meet your wealth management needs, including financial planning, investment management, ESOP diversification, retirement income, insurance, and estate planning. As a fee-based financial advisor based in Chicago, Peak Wealth Planning serves a select group of clients in Illinois and across other states.