Receiving an inheritance may seem like good news, but making a bad decision can be very expensive. That's what a 45-year-old man discovered who inherited his father's IRA (Individual Retirement Account), a type of retirement savings account used in the United States that offers tax benefits and allows you to accumulate money for retirement.
The account had a balance of $290,000. Following the death of his father earlier this year, the man was named as the sole beneficiary. However, his brother, who was not listed as the beneficiary of the account, proposed to withdraw all the money immediately to distribute it between them, without considering the strong fiscal impact that this decision could have.
Why withdrawing all the money at once could be a mistake?
Traditional IRAs work with one important advantage: the money they contain has not been taxed on income. Therefore, when the beneficiary withdraws funds, that amount becomes part of his or her income for the year and must be taxed as ordinary income.
In this case, if the heir were to withdraw the $290,000 in one fell swoop, that amount would be added to their annual income and they would likely end up paying a higher tax rate.
That is, the result would be a much larger tax bill and a significant reduction in the money you would ultimately keep.
There is no penalty, but there are taxes
One important difference is that inherited IRAs are not subject to the 10% early withdrawal penalty, a penalty that may apply when someone withdraws money early from their own retirement account.
However, that doesn't mean the money is tax-free. The beneficiary must pay the corresponding income tax for each withdrawal made.
The law allows you to withdraw money little by little
Current legislation in the United States, known as the SECURE Act, states that most people who inherit an IRA from a parent or relative other than the spouse must withdraw all the money within 10 years.
The good news is that you don't have to take out all the money right away.
The beneficiary can decide when to make withdrawals during that period. In many cases, spreading the money over several years, especially when income is lower, can considerably reduce the total taxes paid.
Are you obligated to share the money with your brother?
No. Because the IRA designates him as the sole beneficiary, the money legally belongs to him. In this type of account, the designation of the beneficiary has priority over what a will may indicate regarding other assets of the inheritance.
That means sharing some of the money with your brother is a completely personal decision and not a legal obligation.
Planning before withdrawing money can make a difference
Specialists recommend that those who inherit an IRA account consult with a tax advisor before making large withdrawals. Good planning can significantly reduce the amount of taxes you will pay over the 10 years allowed by law.
Additionally, the account must be managed following Internal Revenue Service (IRS) rules and kept correctly identified as an inherited IRA, as there are specific rules for these types of accounts.
Avoid a costly mistake
After learning the tax consequences, the man explained to his brother that withdrawing the $290,000 immediately would only result in paying more taxes if he later decided to share the money.
When you inherit an IRA, acting quickly can be very expensive. In the United States, these retirement accounts have specific tax rules, and planning for withdrawals can mean keeping thousands of dollars more from your inheritance.
