'Such a Huge Tax Hit': I Cashed Out a $14,000 Inherited IRA, and Now I Owe the IRS. What Can I Do?
What happens when you inherit a traditional IRA, immediately cash out and file your taxes the following spring?
You find out that the IRS wants its cut.
It's the mistake a Reddit user shared in a post explaining their realization that reporting a $14,000 IRA withdrawal on their tax return means they owe a tax bill of around $2,500.
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"I go from having a substantial refund to owing quite a bit for both federal and state," the post in r/Tax reads. "I didn’t think I was going to take such a huge tax hit."
The poster said they earn about $98,000 per year and inherited the IRA from their mother, who died with various debts and no major assets besides the retirement account. When they cashed out the entire balance of the individual retirement account, they chose to withhold 5% for taxes — an amount that proved to be insufficient.
“I will say that I use free tax software and despise paying for something," the user added. "But if it would mean getting help and not owing this huge amount, I would consider it."
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What to know about lump-sum distributions from inherited IRAs
Individuals who inherit an IRA generally do not have to pay the standard 10% penalty for withdrawals before age 59 1/2. However, when you take a lump-sum distribution, that money is still taxed as income at the federal and state levels.
Under the current federal rules, most non-spouse beneficiaries have a 10-year clock from the time of the account holder's death to withdraw the funds. Spouses and eligible designated beneficiaries may have additional flexibility.
"If they didn't need the distribution, my recommendation would have been to spread it out over a few years," says Julie Hall Labrune, a certified financial planner at Vision Capital Partners in Ann Arbor, Michigan, says. "Say they were falling into the 12% bracket. That distribution easily could have pushed them up into the 22% bracket. From 12% to 22% — that's a big jump."
Immediately withdrawing the entire balance of an inherited IRA is not always a tax mistake, and beneficiaries often need funds to cover a deceased parent's funeral costs or their own cash needs. But it's important to understand the rules and withhold accordingly. This is why financial professionals recommend mapping out these tax scenarios beforehand.
In this case, setting aside 5% was not enough.
So what now? The withdrawal is irreversible, but there are several ways the Redditor can reduce the financial impact on their life. For example, the individual could have adjusted their tax withholding from their regular earnings had they realized the tax hit was coming last tax year.
By tax season, that window has closed. But it's still an option to try to lower your taxable income with last-minute IRA contributions, Hall Labrune adds. (For those strategies to work, a taxpayer has to fall under income cutoffs.)
A last option would be to consider an IRS payment plan, Hall Labrune says. Given the complexity of this tax problem, it could be best to seek professional advice rather than relying on free tax software.
"Go meet with a CPA," Hall Labrune says. "Have them look everything over, just to make sure there isn't anything that they might be able to do."