It’s always a pain to talk about money stuff. So much effort goes into managing their finances and making sure the IRS gets their fair share. The problem becomes even more complex when you’re dealing with inherited money instead of money that you earned from work or as a gift.
If you’ve recently come into money after a loved has passed away, you’re probably wonder many things when it comes to your newly-acquired money. Things such as how much you have to pay in taxes, whether you’re exempt or not, and whether or not you’re eligible for any kind of deductibles are probably just some of the questions that come to mind.
IRAs and other finances can be hard to handle as it is, and it can be doubly hard to keep your head on straight while you’re still grieving a loss. To help you out, these are the answers to nine important, frequently asked, tax-related questions that every adult child who’s inherited money should ask themselves.
1. I’ve just inherited an IRA – how fast should I act?
It’s very important that the less financially inclined speak with a wealth management firm of some kind. Wealth management firms can help steer grieving children in the right direction and educate them on what their options are. Children can learn all about the tax on inherited IRAs and what taxes they can avoid. These firms can also tell people what they should and should not be doing with the money as they plan their next steps.
It’s important to claim the IRA quickly, before the end of the calendar year. If your parent or whomever left you the IRA was not 70 ½ years old or older when they passed away, it’s important to withdraw the required minimum distribution (RMD) before December 31st. BankRate writes that failure to do so can leave you subject to penalties.
The age of your parent plays a huge role in this, as does the date they died. A parent who died close to the end of the year leaves you less time to handle the RMD. And yes, this all still applies even if your parent were to die extremely late in the year, such as December 27th.
2. What is an inherited IRA?
An inherited IRA is, as the name implies, an IRA that a person has inherited from a deceased person’s estate. A person typically has to name a beneficiary of the IRA in their will before they pass away, however IRAs can be inherited even in the absence of a will. In the case of inheriting an IRA without a will, the assets of the deceased are passed on to the spouse or divided among living children.
IRA’s don’t need to be passed onto spouses or blood relatives, either. It’s completely possible and legal for a person to set it up that a friend, business partner, step-sibling, or even in-law. The IRA can also be left to organizations such as charities. It’s really all up to the original owner of the IRA to decide how its handled after they pass away.
3. Do I claim the inherited IRA as income on my taxes?
Though this article will go into more detail on this later, you don’t always have to pay income tax on an IRA. Distributions and withdrawals claimed from an IRA can be taxed as income taxes, but you may not have to pay it yourself when you come into possession of the IRA.
As BankRate further writes, as long as the taxes were initially paid, it doesn’t matter if it was you or the one that opened the IRA who paid it.
4. Is there such as thing as an inheritance tax?
Yes there is! In the case of inheritance taxes, this is a tax that the recipient – not the estate of the deceased person – has to pay. It’s a rather uncommon tax though, since only six of the fifty states have this tax, and most beneficiaries are exempt from paying this tax. The states have an inheritance tax are Pennsylvania, Kentucky, Nebraska, New Jersey, Iowa and Maryland.
It’s important to remember that even though forty-six states don’t have an inheritance tax, all states have income taxes that you have to worry about. All withdrawals and money taken from an IRA have to be taxed as income.
5. How do inheritance taxes work?
These inheritance taxes have to be paid after an executor has divided up the assets and distributed them to the beneficiaries. Percentages of inheritance taxes vary by state, and can be anywhere from 1 percent to twenty percent. Of course, the higher the percentage, the more you have to pay in taxes. It’s important to educate yourself on your state’s individual inheritance laws, if it has any.
Again, only a handful of states have an inheritance tax. It’s a rather rare tax that isn’t unique to any one region. As mentioned in section three, states in the north, south, east coast and Midwest have inheritance taxes. A quick google search will show you whether or not an inheritance tax is something you have to worry about; if it is, you should be able to easily find out what percentage an inheritance tax takes.
6. How will I know if I have to pay any taxes on an inheritance?
There are many reasons why you may be exempted from paying an inheritance tax, if you live in a state where inheritance taxes exist. For example, spouses who receive an inheritance from their spouse are exempt, as do children and dependents. However in the case of children, only a portion of the inheritance may be exempt. Those who don’t have any familial relations to the deceased likely will not be exempt, and will have to pay the inheritance tax.
In addition, if you were to cash out the IRA instead of retitling it, you could potentially have to pay income taxes, according to AARP. As mentioned before, if you’re required to make an annual withdrawals from the IRA, that too is taxed each year as income.
7. Do I get any tax breaks?
BankRate writes that those that receive an IRA will receive an income-tax deduction applicable to the taxes that are paid for the estate, although this only refers to estates that are affected by the estate tax. In simpler words, this essentially means that you won’t have to pay as high of an income tax on the IRA’s income. The official phrasing to refer to this kind of income is “income in respect of a decedent”.
Tax deferrals on an IRA could also last even after the IRA has transferred to the beneficiary. 401(k)s can also be retitled as IRAs after a beneficiary has inherited it. This is all extremely important for adult children to note; they should be aware of all the options they have, and not be forced to pay out more than they have to.
8. What is retitling an IRA?
Retitling an IRA is just that: changing the title on an IRA to now reflect the both the original owner and beneficiary, instead of just the owner. Retitling is very important in avoiding paying unnecessary income taxes, and can help carry tax deferments potentially for decades, with would greatly benefit the beneficiary.
It’s also important to note that inherited IRAs should be retitled by the beneficiary, as AARP goes on to write in their aforementioned article. This is typically what happens in the case of younger spouses who are under the age of 59 ½. If a younger spouse tries to withdraw money from an inherited IRA without retitling it, they run the risk of having to pay a penalty. The name of the beneficiary should be identified in the title of the IRA.
To use a similar example to AARP’s, if Jack Smith’s IRA should be retitled by his surviving spouse Jessie to “Jack Smith IRA (deceased Aug. 1, 2012) for the benefit of Jessie Smith, beneficiary”. This retitling would allow Jessie to withdraw money from her inherited IRA without having to potentially pay the 10 percent penalty.
This method also applies to children. Children who inherit an IRA from a deceased parent should retitle the IRA exactly the way Jessie Smith would. If an IRA is divided among multiple children, each adult child must retitle their share with their own name. Retitling and keeping the IRA helps to avoid income taxes that a child would have to pay if they were to cash out the IRA, as is mentioned above in part two.
Hopefully this article has helped you greatly in understanding taxes and tax laws surrounding IRAs. Not only do IRAs have specific taxes that certain states enforce, but there are many ways to get around paying income taxes. Different rules apply to kids compares to spouses and non-relatives, so it’s greatly important that an adult child that has inherited an IRA knows what their rights and options are.