Your inherited retirement account can be a “tax bomb,” an adviser says. How to avoid it

If you’ve owned a pre-tax retirement account since 2020, you could face a big tax bill without proper planning, experts say.

In the past, heirs could take the IRA money inherited throughout their lives, known as a “stretch IRA.”

However, the Safeguards Act of 2019 created a “10-year rule,” which requires certain beneficiaries, including older children, to liquidate inherited IRAs within 10 years of the spouse’s death. a primary account.

But waiting until year 10 to fund an IRA “could mean sitting on a tax bomb,” said certified financial planner Ben Smith, founder of Cove Financial Planning in Milwaukee.

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Pre-tax IRA withdrawals result in normal taxes. The 10-year rule can mean higher annual taxes for certain beneficiaries, especially high-income earners with large IRA balances.

Shortening the 10-year window could add to the problem, experts said.

Larger withdrawals can increase your adjusted gross income, which can have other consequences, such as higher tax rates or the flow of other tax benefits, Smith said.

For example, Smith has seen people lose eligibility for the electric car tax credit, worth up to $7,500, by taking too much inherited IRA money in one year.

As of 2019, there has been confusion about whether certain beneficiaries need to take annual withdrawals, known as required distributions, or RMDs, during the 10-year window.

After years of repeal penalties, the IRS finalized the RMD rules for inherited IRAs in July.

Beginning in 2025, other beneficiaries — non-spouse beneficiaries, a minor, disability, chronic illness or certain trusts — must begin taking annual RMDs to inherited IRAs. The RMD rule applies if the original account holder reached their RMD age, or “required starting date,” before death.

Beginning in 2020, the Safeguard Act raised the required start date for RMDs to age 72 from 70½. But Secure 2.0 added two collections: RMDs starting at age 73 starting in 2023, and age 75 in 2033.

Even when RMDs are not required, heirs should still consider spreading inherited IRA withdrawals, experts say.

“If you decide not to take a distribution from an inherited IRA in a year and it continues to grow, the tax bill increases as well,” according to CFP Carl Holubowich, principal of Armstrong, Fleming & Moore in Washington, DC “That money will be taxed at some point, it’s just a matter of time.”

Some heirs may take larger IRA withdrawals in lower-income years during a 10-year window or other tax planning methods, experts say.

Individuals can also consider future federal income tax brackets, IRA expert and certified public accountant Ed Slott told CNBC earlier.

Without changes from Congress, many tax rates, including the lower federal tax brackets, will expire after 2025. That could return rates to 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.

“Every year you don’t spend [the lower brackets] it’s a wasted opportunity,” Slott said.

But with control of the White House and Congress uncertain, it’s hard to predict how federal tax brackets will change after 2025.