Why Taking the Lump Sum Could Cost You Thousands in Taxes
When someone inherits an IRA, emotions often take over before logic does.
A parent passes away. A spouse dies unexpectedly. A loved one leaves behind a retirement account that may represent decades of hard work and disciplined saving.
Then comes the $64,000 question.
"Should I just take all the money now?"
In most cases, the answer is a resounding no.
In fact, the single biggest mistake people make when they inherit an IRA is taking a lump-sum distribution without understanding the tax consequences.
While it may feel tempting to cash out the account, pay off debt, buy a new home, or simply put the money into your bank account, that decision can create a tax bill that is far larger than most people expect.
The IRS Wants Its Share
Many beneficiaries don't realize that a traditional IRA has never been taxed.
Every dollar contributed to the account either reduced taxable income or grew tax-deferred over many years. When the money finally comes out, the IRS gets paid.
Let's look at a simple example.
Suppose you inherit a traditional IRA worth $500,000 from your father or mother as a non-spouse beneficiary.
You already earn $150,000 annually from your job.
If you withdraw the entire $500,000 in one year, your taxable income could jump to $650,000.
That sudden increase may push you into significantly higher federal and state tax brackets. Depending on where you live, you could potentially lose 35% to 45% of the inheritance to federal and state income taxes.
That means a $500,000 inheritance could shrink to nearly $300,000 after taxes.
That's a painful and unnecessary haircut.
The 10-Year Rule Changes Everything
Under current law, most non-spouse beneficiaries must empty an inherited IRA within 10 years.
Many people misunderstand this rule.
They assume the government is forcing them to take all the money immediately.
That's not true.
The IRS generally gives you up to 10 years to distribute the assets. This flexibility can be incredibly valuable because it allows you to manage the tax impact strategically.
Instead of taking $500,000 today, you may be able to spread withdrawals over multiple years, potentially keeping yourself in lower tax brackets. This is where Exit Wealth® plays an important role with our members, helping to artfully build a ten-year tax plan.
The difference can potentially amount to tens of thousands or even hundreds of thousands of dollars in tax savings, depending on individual circumstances.
Timing Matters More Than Most People Think
One of the smartest strategies is coordinating IRA distributions with lower-income years.
Perhaps you're planning retirement.
Maybe you're selling a business.
Perhaps you're taking a sabbatical or transitioning careers.
These lower-income periods may provide opportunities to withdraw inherited IRA assets at substantially lower tax rates.
I've seen families save enormous amounts simply by creating a distribution plan rather than reacting emotionally after inheriting the account.
Don't Forget About Your Other Income
Another common mistake is ignoring how inherited IRA distributions interact with other financial decisions.
Large withdrawals can:
- Increase your Medicare premiums.
- Trigger taxation of Social Security benefits.
- Reduce eligibility for certain tax credits.
- Push investment income into higher tax brackets.
- Increase state income taxes.
The true cost of a lump-sum distribution often extends well beyond the federal tax bill.
Spouses Have Additional Options
If you're a surviving spouse, you may have even greater flexibility.
In many situations, a spouse can roll the inherited IRA into his or her own IRA and continue tax-deferred growth.
This can create opportunities that are not available to children or other beneficiaries.
That's why it's critical to understand your specific beneficiary status before making any decisions.
Slow Down Before You Cash Out
When people receive an inheritance, they often feel pressure to "do something" immediately.
But inheriting an IRA isn't like inheriting a checking account.
The money has tax strings attached.
Before taking a distribution, sit down with a qualified tax advisor, CFP®, or CPA who understands inherited IRA rules.
The goal isn't just receiving the inheritance. It's keeping as much of it as possible.
Because the biggest mistake when inheriting an IRA isn't waiting too long. It's taking the money too fast.
And the IRS is more than happy to collect the difference.
Isn't it time we sat down with you at Exit Wealth® to review this important financial moment in your life?
Ted Jenkin
CFP®, AWMA®, AAMS®, CEPA® Managing Partner & Chief Marketing Officer · Exit Wealth®
The Exit Wealth® Team
All opinions expressed in this newsletter is for general informational purposes and constitutes the judgment of the author(s) as the date of the newsletter. The opinions and views expressed by the author are personal and based on economic or market conditions at the time of publication. Actual economic or market events may turn out differently than anticipated. Nothing in this material is intended to serve as personalized investment, tax, or insurance advice. These opinions are subject to change without notice and are not intended to provided specific advice or recommendations for any individual.
The material has been gathered from sources believed to be reliable, however Exit Wealth® cannot guarantee the accuracy or completeness of such information, and certain information presented here any have been condensed or summarized from its original source. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always, please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.
