Tax Implications of Inheriting an IRA, Roth IRA, or Taxable Account
Don't let your inheritance get hit with a massive tax bill! Tim breaks down the key tax differences among 3 major investment account types - tax-deferred, taxable, and Roth IRAs - and how each one is impacted when inherited.
Today, I’m going to cover the three main types of investment accounts and the corresponding tax implications of inheriting each separate type of account.
3 Account Types
Basically, we have three different account types:
- Tax-deferred accounts, pre-tax accounts like our 401(k)s, IRAs, 403(b)s, and anything like that
- Taxable accounts, which would be stuff like our individual accounts or joint accounts, anything that if you sell something and have a gain or loss, that creates a taxable event
- Roth IRAs, which are our best accounts because they are after-tax money and any growth that you get in those accounts is going to grow tax-free.
We love Roth IRAs at my firm. Sometimes there are reasons that we might not have a Roth IRA, but generally, if we can get money into a Roth, that's a good thing.
Tax Implications of Each Account Type
Tax-deferred accounts - Ordinary income tax brackets
If we buy a stock in a tax-deferred plan or an IRA, when we take that money out, it's going to be taxed at our own income tax rates because we haven't paid income tax on any of the contributions. And Uncle Sam wants his share of the money!
So we're going to get taxed on the distribution at whatever marginal tax rate we’re at in the year we take the money out. And it’s going to be taxed at our seven-bracket ordinary income rates.
Remember, our seven-bracket or seven-bucket system is what our regular ordinary income is taxed at. Those rates go from 10% all the way up to 37%. And it's marginal, so that means that you only pay that rate on the income that falls in that bracket.
So, if you are in the 12% bracket and you make an extra $1,000 that puts you into the 22% tax bracket, only that extra $1,000 will be taxed at the 22% rate. Any amounts below that will be taxed in their respective brackets (10% and 12%, in this case).
Taxable accounts - Long-term capital gains and qualified dividends rates
Now, we also have our three-bracket qualified dividends and long-term capital gains rates. These are preferred to our seven-bracket ordinary income rates because they are quite a bit lower. Here we only have a 0% bracket, a 15% and a 20% bracket, so they are much preferred to our 7-bracket ordinary income rates that go from 10% all the way up to 37%.
Now, let's say we buy a stock in a taxable account like a joint or individual brokerage account. If we hold that stock for over a year, it's going to be taxed at the preferable three-bracket system of long-term capital gains and qualified dividend rates.
Roth accounts - Tax free!
If we buy something in a Roth account, it comes out tax-free at the end because we have already paid tax on the contributions to that account. The great thing about a Roth account is that if it grows a lot, all of that growth is coming out tax-free. That's why we love Roth accounts at my firm.
Inheriting Each Account Type
Now that I have covered the tax implications of each account type, let’s discuss what happens when these different account types are inherited.
Tax-deferred accounts for beneficiaries
First, pre-tax money. If you are a beneficiary and you’ve inherited pre-tax money, like a traditional IRA, whenever you take money out of that pre-tax account, the withdrawal is going to be taxed at your ordinary income rates, just like it would have been if the original owner had taken the money out. But now, of course, it'll be taxed at your marginal tax rates, not the original owner’s rates.
Unfortunately, the SECURE Act did away with the stretch IRA. This is very frustrating because let's say your parents have built up a nice pre-tax retirement account, and then they pass away and that account goes to you now, or whomever the beneficiaries are.
Statistically, you are going to be in your 50s and 60s in your highest earning years when you inherit that money.
So now you have to take out that pre-tax money in your highest earning years. And that is additional income that is going to stack on top of your income in your highest earning years. And you have to take that money out within 10 years because of the SECURE Act.
The stretch IRA used to let beneficiaries inherit and then extend over their own lifetime how much they had to take in required minimum distributions. Now beneficiaries are required to withdraw all of the money within 10 years, typically at their peak income years, which of course, is a sneaky way for Uncle Sam to get more of your inheritance.
This can end up really creating a tax bomb for you, as the beneficiary.
Taxable accounts for beneficiaries
Next, what happens in a taxable joint or individual brokerage account? This is actually pretty good.
Let's say your parents had a stock that they bought at $10 and it grew to $100, and it's in their taxable account. If they still owned that stock when they pass away, it will now be left to you, as the beneficiary, but it will now be like you purchased the stock at $100. That is known as step-up in basis.
Step-up in basis is obviously a good thing for beneficiaries, at least in terms of lowering taxes. Now, in certain situations, if we know somebody is terminally ill or probably not going to last much longer, we can do some tax planning around that.
I know, nobody likes to talk about this because nobody likes to consider their own mortality, but there are tax planning opportunities if you want to reduce taxes for your legacy.
So, like I said, if the stock was bought at $10 and it grows to $100, and your parents or benefactor passes away, then it would be as if you just bought the stock at $100. Then you could sell that stock the next day for $100 and not pay any capital gains tax. Again, that is step up in basis.
Roth accounts for beneficiaries
Now, what happens if you have the money in a Roth IRA? Well, if it’s qualified, it's a tax-free account. If you are the beneficiary of that money, it still has to come out within 10 years because of the SECURE Act, but the tax has already been paid on it, so it doesn't create a tax bomb.
As I mentioned, Roth IRAs are the most beneficial account and you want to leave the money in there as long as you can if you are a recipient of an inherited Roth IRA because it's still a Roth and it will grow tax-free.
So that wraps up the implications of inheriting the 3 different account types: traditional IRAs, Roth IRAs, and taxable accounts, and how step-up in basis works if you inherit an ordinary taxable brokerage account.
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