If inheritance comes to me tax-paid, why do I still have to pay taxes on my inheritance?
Great question. If you inherit IRA or 401k tax-deferred money, it is taxable. Since the rules recently changed, let’s go over what tax-deferred funds are, why they are taxable, and how long you have to pay the taxes.
What are Tax-Deferred Funds?
When you put money in a traditional IRA or 401k or similar plan, you are probably doing it for the immediate tax benefits in addition to saving for retirement. You put money in, the money is not taxed this year. You don’t pay the taxes until you take it out. Great deal.
However, when it is in the fund, it is not ‘your’ money. It is held by a bank somewhere. You can’t pay bills with it or use it as collateral to borrow money. You can’t collect the interest on it. It is not ‘yours’. The minute you treat it as ‘yours’ or get any benefit from it, you have to pay the taxes on it. As long as it stays with your trustee (the bank), it is in under a safe umbrella, shielded from taxes. The money was never tax-free, you just postponed paying the taxes.
Why Do I Have to Pay the Taxes?
If someone dies and has tax-deferred money, the taxes still need to be paid. The money is held by the trustee awaiting the day it becomes taxable. If you ‘inherit’ IRA or 401k funds, you are a named beneficiary. The funds come to you, and YOU are required to pay the taxes on it. “Why do I owe taxes on my inheritance?” Because your loved on never paid the taxes.
Rules for Paying the Taxes
The rules changed in 2020 for paying the taxes. (IRS Regulations) Previously, you had five years to withdraw the funds and pay the taxes. Since 2020, you have ten years. That means you can take out a little each year, take a different amount each year, amount every year, or leave it all and take it out at the end of ten years.
If you got a considerable amount of money like this, you should check with a tax professional before you liquidate it in one year, put yourself in a scary tax bracket and pay far more taxes than you need. Always run a few scenarios to pay the least amount of tax.
Remember that the additional income will affect the tax credits for your kids, the price of your marketplace healthcare, educational assistance, taxability of social security payments, and many other things. Always consult a professional before withdrawing a large sum of money.
Remember to Report Your Payments
When you make withdrawals, you will get a 1099-R at the end of the year and you need to report it as retirement income, even if you are not retired, even if you had taxes withheld.
The withheld taxes are a deposit on the tax on your total income for the year. Just like the amount they hold out of your paycheck each week. You have to report ALL your income and all the taxes deposited for the year when you file.