Q&A: What are the Tax Rates for an Inherited IRA?

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Inheritance, almost uniquely, has the ability to anger both those who believe in equality of means and those who believe in equality of outcome. Imagine a wealthy father who was able to amass more wealth than another similar dad; this is inequality of outcomes. And then that wealthy deceased father passes his fortune on to his one child while the poorer dad passes on very little and divides it among his three children. This creates an inequality of means for the next generation.

Although equality may divide party lines, the jealousy and bitterness surrounding inheritance may not be divided. Most people just hate heirs.

Unfortunately, this means that inheritance rules and taxation is often some of the most restrictive and punitive regulation.

On the topic of inherited individual retirement accounts (IRAs), I recently received the following reader question:

Is an inherited IRA taxed at the deceased parent’s tax rate or the child’s income tax rate?

The short answer is that most taxable distributions from inherited IRAs are taxed at the the child / beneficiary’s income tax rate.

The longer answer is that there are multiple chances for inheritance to be taxed.

Probate Fees

If you accidentally forget to name beneficiary designations on your IRA, then your IRA will find its heirs through a process called probate.

Probate is the formal reading of your will with a probate officer from your local circuit court. All your probated assets are subject to probate fees and taxes and are distributed on public record to the beneficiaries in your will. Your executor is required to provide detailed accounting down to the trade lot for all the assets in probate. Then, adding insult to injury, they must pay a fee based on how many pages are in these accounting reports.

Being an executor is a difficult, mostly thankless job, often compounded by grief at the loss of a friend or loved one. If you can make all your assets avoid probate, then you will be doing a great service to your beneficiaries. Unfortunately, if your assets do end up in probate and if your IRA manages to survive the process intact, the heir is then faced with the most unfortunate Inherited required minimum distribution (RMD) rules. Because they did not inherit the IRA from a beneficiary designation, they must distribute their RMD under the 5-Year Rule, meaning 1/5 of the initial account value each year so that the whole account is distributed in five years. This is true even under the new SECURE Act legislation.

The easiest way to avoid probate and its fees is to set both primary and contingent beneficiary designations on all your retirement accounts.

Estate Tax

Another tax IRAs may be subject to is the estate tax. At 31 pages in length, the Estate Tax return is daunting. Luckily, many estates do not require the estate tax return. A filing is only required for estates with combined gross assets and prior taxable gifts exceeding the estate exemption limit for the year of death; though if you are the surviving spouse you may elect to file so you can reserve any unused exclusion. Right now in 2020, the estate exemption limit is $11.58 million per individual.

If you do exceed the limit, then any IRAs you owned when you died will be included in the valuations and may be subject to estate tax.

There are a few complex estate strategies to avoid the estate tax which an estate attorney can help you find. The easiest way to implement estate tax avoidance is to simply not have an estate that large. This can be accomplished by spending more money and enjoying your own life more or by gifting up to the gift limit to those who you love each year. If you have grandchildren, one strategy for reducing the size of your estate and using up your gift limit is to fund your grandchild’s 529 plan.

Income Tax

After having paid any probate and/or estate taxes owed, the IRA can finally be inherited by its beneficiary. If the IRA is a traditional pre-tax IRA, then distributions from the account will need to be included in the beneficiary’s tax return and is taxable as regular income. If the IRA is a Roth IRA, then the assets are post-tax and distributions are not a taxable event.

If the beneficiary is a trust, then there is another level of complexity. Some trusts retain control of the assets they inherit, such as common pot trusts, disability trusts, or many child trusts. These types of trust remain the owners of the IRA and, as a result, may subject some or all of the taxable distributions to their trust tax rates. Income included on the trust tax return which is not distributed to the beneficiaries will be subject to the likely higher trust income tax rate.

Distributions made to the beneficiaries of the trust see the taxable income shifted onto the beneficiary’s tax return. In this way, IRA distributions would be subject to taxation at each beneficiary’s income tax rate.

However, if the trust does not distribute assets, then, without any distribution deduction, the income is taxed at trust tax rates. The trust tax rates are compressed with higher percentages reached more rapidly, making the trust return more expensive than any other return.

To avoid the compressed tax rates of the trust tax return, try to leave your IRAs directly to your heirs (if it matches your wishes) or to a trust which has been carefully crafted to distribute IRA distributions directly to heirs.

So what tax rate are inherited IRAs subject to?

It is the tax rate of the heirs, be they individual or trust, but with potentially unwanted fees and taxes along the way. Careful estate planning before you die can save your heirs a lot of fees, taxation, and complexity.

This is one reason that you should take the time to not only create estate documents but ensure they are implemented properly.

Photo by Marisa Morton on Unsplash

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Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.