If you've inherited a Roth or Traditional IRA from your spouse, here's how to prevent unnecessary taxes on that account.

As you navigate the emotional impact of losing a partner, tax laws might not be at the forefront of your thoughts. However, the IRS imposes strict timelines before taxes come into play on an inherited IRA.

If you're the sole beneficiary of your spouse's IRA, things are relatively straightforward. The IRS treats the account as your own, which simplifies the associated tax responsibilities.

  • You can contribute to the IRA up to the annual limit set by the IRS based on your income. For 2020, that limit is $6,000, or $7,000 if you're over 50.
  • When it's time to take withdrawals, the tax obligations will depend on your personal situation.

These are the basic inheritance rules for IRAs. Yet, there are specific intricacies within the IRS tax code that you need to be aware of to avoid unexpected taxes.

7 Essential Steps to Minimize Taxes on an Inherited IRA

Wealth transfer can be complex. By adhering to the guidelines, you can steer clear of tax liabilities. Here's a look at common pitfalls to avoid:

1. Keep IRA Types Separate

There are various IRA types, but Roth and Traditional are the primary ones. (Here's a comparison.) If your spouse has left you a Roth IRA, be sure to transfer the funds into an existing Roth IRA or establish a new one. The same principle applies to a Traditional IRA.

>> RELATED: How to Open an IRA

For non-spouses or those inheriting alongside other beneficiaries: You can't transfer funds into existing IRAs or make additional contributions. Instead, set up a new IRA for your inherited funds.

2. Sidestep the 10% Early Withdrawal Penalty

With a Roth IRA, you can withdraw your contributions at any time without tax or penalty. This same rule applies to you as a spouse with an inherited Roth. However, be cautious regarding earnings. Generally, you must be at least 59 ½ to withdraw Roth IRA earnings without incurring a 10% penalty. For Traditional IRAs, you must also wait until 59 ½ to take withdrawals without penalty.

Note: Under the CARES Act, the IRS has temporarily waived the 10% penalty for certain coronavirus-related withdrawals, allowing you to spread out tax obligations over three years.

3. Follow the 5-Year Earnings Rule

You can cash out Roth IRA contributions anytime, regardless of age. However, earnings come with two stipulations: 1. You typically need to wait until age 59 ½ to withdraw earnings without incurring a penalty. 2. Earnings must be held for at least five years before you can access them tax-free. The 5-year countdown begins when the original account holder opened the account.

4. Withdraw Funds by Age 72

Mark your calendar for the year you turn 72, as that's when you must start taking required minimum distributions (RMDs) from both your own Traditional IRA and any inherited accounts. (Learn more about IRA withdrawal regulations here.)

Thanks to the CARES Act, RMDs are temporarily suspended for the rest of 2020, allowing you to defer taxes on traditional IRA assets until at least 2021.

5. Be Aware of the New 10-Year Rule

The SECURE Act introduced changes regarding IRA inheritance. For spouses who aren't the sole beneficiaries, certain heirs must withdraw all funds from the inherited account within ten years following the original owner's death. Fidelity provides a comprehensive overview of the SECURE Act impacts.

6. Plan for Lump Sum Distributions

If you're considering taking a large withdrawal from an inherited IRA, be cautious. Withdrawals from a Traditional IRA will be taxed as income for that year. Taking a substantial amount can elevate you into a higher tax bracket.

For many, it's often wiser to stagger distributions over several years to minimize tax impact. Assess your current financial situation or consult a financial advisor before proceeding.

7. Steer Clear of the 50% Penalty

This advice applies to everyone, not just those inheriting an IRA. The IRS rigorously enforces RMDs, and failing to comply could result in a hefty 50% penalty tax on the amount you should have withdrawn. If you qualify for the temporary RMD waiver, you may avoid penalties this year. However, stay informed about changing tax laws to ensure you don't unintentionally forfeit a significant inheritance. Given the complexities surrounding IRA inheritance, consulting a financial expert can provide clarity and guidance.

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