September 11, 2014

You Probably Shouldn't Cash Out a Large Inherited IRA

A lot of retired people now have IRA accounts and when they pass they will leave the IRA accounts to their heirs.    When someone inherits an IRA they are liable to pay taxes on it since its all pre-tax income.   The heir gets to choose between 3 basic options : 

  1. cash it out as one lump sum
  2. roll the IRA into an Inherited IRA then cash out in 5 years
  3. roll into Inherited IRA and cash out over your lifetime
All three options do require you to pay regular income taxes on the money.

The problem with #1 can be that this large lump sum of money can easily move you up into a much higher tax bracket and you'll owe significantly more money in taxes than if you spread it out over time with the Inherited IRA.

Lets look at an example.   Say you're married with about $55,000 of taxable income.  That puts you in the  15% marginal tax bracket.    You inherit $100,000 from a relative.   If you pull that out in a lump sum then your tax bill would be mostly in the 25% bracket and a little in the 28% bracket.   If you do the lump sum you'd be paying about $23,300 in taxes.   On the other hand if you went with option 2 from above and pulled the money out over 5 years then you'd be taking out $20,000 a year and most of it would be taxed at 15%.   Your annual tax would go up $3120 on that $20,000 increase for a total tax bill over the 5 years of $15,600.     Thats a tax savings of $7700


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