tax questions about an inheritance

July 16, 2021 10:40 AM

I inherited some money from my aunt, in the form of an IRA. I'd like to use some or all of that money as a down payment on a house, but since it's an IRA, my understanding is that I'd end up paying a penalty for withdrawing it early. I know pretty much nothing about finances, and trying to read stuff online often makes me more confused. What's the best way for me to use this money to buy a house while incurring the smallest possible penalty? Is there a way?

Because it seems to matter, I'm 40, this would be my first house, and my aunt died earlier this year. My wife and I have some savings aside from the IRA, but in this market it seems like more down payment is better, right?

ELI5. This stuff makes my head spin.

posted by kevinbelt to Work & Money (15 answers total)

It appears you can use the money for a home purchase regardless of your age (and are not limited to $10k like you would be with your own IRA) but be aware any money you take out will be taxable income and could move you into a higher tax bracket.
posted by yerfatma at 10:46 AM on July 16, 2021 [1 favorite]

You should talk to your tax person. If your aunt was at the age where she was having to withdraw money from the IRA (it becomes mandatory after a certain age), then the IRS is expecting to see that tax money from the withdrawals she would be making if she were still alive. You most likely do not get the IRA money as some fresh, new IRA that's now yours, you'll get it as an inherited IRA, and will probably have 10 years to empty the account. The only reason not to withdraw it is to avoid being kicked into a higher tax bracket. The financial institution that holds the IRA will probably set it up this way for you and be able to advise you on what the requirements are.
posted by LionIndex at 10:54 AM on July 16, 2021

Do you know whether it's a Roth IRA or a traditional IRA? The rules may be different, and I can only speak to inherited traditional IRAs.

For a traditional IRA, since it came to you from someone other than a spouse, my understanding is that you can choose to cash out some (or all) of it now and there's no penalty. But you *will* have to pay taxes on the amount you withdraw. So you may want to set some aside to be sure you can pay the tax bill on your withdrawal next year. With my brokerage, I can choose to have the brokerage automatically take out taxes from my inherited IRA before they send me the check or electronic transfer on the remainder, so I'm not as worried about that, but I'm not sure if that's a standard brokerage feature or not.

If you choose not to cash it all out now, you should be aware that you're required to withdraw it all within the next ten years anyway, so while you could potentially gain some additional money by leaving it alone for ten years, are you confident enough in your investment ability / the market that it's worth it to you to sit on it for ten years? That's your call but it's something to consider. (Also, double check that I'm right about the ten years - my inherited IRA predates that regulation so I'm under a different set of rules about how long I have to make withdrawals. This article indicates there might be some exceptions to the ten-year thing that you could investigate.)
posted by Stacey at 10:54 AM on July 16, 2021 [3 favorites]

No, you won't owe a penalty. "If you inherit a traditional IRA, you can cash out the account at any age -- even before you reach age 59½ -- without having to pay a 10% early-withdrawal penalty. But you will have to pay taxes on the money in the account (except for any nondeductible contributions)." If it's a Roth IRA, you won't owe taxes on it.

The financial institution that holds the IRA should be able to help you with basic questions.
posted by Mr.Know-it-some at 10:54 AM on July 16, 2021 [3 favorites]

Additionally, you may have a mandatory minimum withdrawal amount per year.
posted by LionIndex at 11:00 AM on July 16, 2021 [1 favorite]

Another detail that you may be wondering about: you will receive a separate tax document from your brokerage around the same time as your other tax documents arrive, documenting the withdrawals you make and any taxes that the brokerage withholds for you. It's called a 1099-R and it's no more difficult to enter into your tax software than your standard W-2 or 1099 or however else you get your usual salary. So just keep an eye out for that form when it shows up, you'll need it come tax time. If you withdraw multiple times over your ten year window, you can expect a form for each year you make a withdrawal.
posted by Stacey at 11:05 AM on July 16, 2021

Response by poster: "The only reason not to withdraw it is to avoid being kicked into a higher tax bracket"

I'm right on the edge of a higher tax bracket already, so pretty much any amount of money I withdraw would kick me higher. Given that, is it better to withdraw it all in one lump sum? Would it make sense to withdraw some this year and some at the beginning of next year? It will probably all be taxed at the same rate, just a question of me paying the taxes, right?
posted by kevinbelt at 11:08 AM on July 16, 2021

You should probably find out if you have a mandatory withdrawal, how much it is, and what that ends up doing to your status. Since tax rates are progressive, it's not like ALL your income will be taxed at a higher rate once you cross a tax threshold, only the portion over the threshold will be taxed higher. So if the mandatory withdrawal kicks you up one notch, but the entire amount isn't enough to take you over a bracket additional to that, then personally I wouldn't have a problem with taking the whole thing out.

The other reason not to withdraw everything is if it's in some investment that makes more money than what your interest rate for your home loan (or if you can put it in such an investment).
posted by LionIndex at 11:30 AM on July 16, 2021 [2 favorites]

Would it make sense to withdraw some this year and some at the beginning of next year? It will probably all be taxed at the same rate, just a question of me paying the taxes, right?

there might be limits on how many times in 12 months you can withdraw, so i would ask about that.
posted by domino at 11:30 AM on July 16, 2021

"Being kicked to a higher tax bracket" isn't always a bad thing. And specifically, it doesn't require that you pay higher taxes on any money that's already in the lower tax bracket. It's possible that making more money will cost you more money because of impact on things outside the tax system - like child support, or insurance, or social assistance programs. But it won't be because of the tax rate itself. Maybe you understand the progressive tax rates, but if you don't, please take a look and don't fear the next tax bracket if you don't understand it.

It's also possible that the money will be taxed at capital gains rates - which are 0, 15, or 20% on long term gains (the first $40,000 in gains isn't taxed).

I guess it's possible that you would be better off waiting to withdraw money from the account until that specific money will be taxed at the lower rate, either because you have other realized capital gains, or because it's going to be taxed as income for some reason.

Ask the company managing the funds. They will have real answers.
posted by dpx.mfx at 11:43 AM on July 16, 2021

Just to spell this out: Let's say the tax rate is 10% for income up to $100,000, 20% for $100,001 to $200,000, and 30% for $300,000+. (These are in no way related to actual rates, but it makes the math simple.)

Let's say you make $100,000 every year and inherit a $200,000 IRA. If you withdrew it all at once, the tax on the IRA would be $50,000: 20% of the first $100,000 and 30% of the second $100,000.

If you withdrew it over 2 years, the tax would be $40,000: $20,000 each year. But in this scenario, withdrawing it more slowly than that wouldn't result in any further tax savings.

Unfortunately, the only way to figure out how much tax savings you could actually achieve is to look at your actual income and the actual tax brackets. Then you can decide whether it's worth worrying about.
posted by Mr.Know-it-some at 11:54 AM on July 16, 2021 [3 favorites]

My understanding is the mandatory withdrawals were the old way pre-SECURE Act; they've been replaced with the new "you have ten years to withdraw it, but within that time you can space it out however you want" rule.

I just inherited an IRA in February and was told I had a mandatory withdrawal, but maybe that's just for this year since the decedent was around and already made a withdrawal earlier in the year.
posted by LionIndex at 12:29 PM on July 16, 2021

The rules may be different for inherited IRAs but for your own IRA if you're a first-time homebuyer, there are things you can do.
posted by lalochezia at 12:55 PM on July 16, 2021

It used to be that tax brackets affected your entire income. That has not been the case for quite a while. Initial income is taxed at 1 rate, income over a threshold is taxed at a higher rate.

Your relative saved the money pre-tax, so it's going to be taxed. Taxes are at historic lows, so this is the least expensive it will likely be.

You probably have to take required distributions. You might not have to take a distribution this year because of the Pandemic. The IRA is being held at a bank of some variety, call them and ask; it's their job to tell you all about it, and it's okay to ask for a more experienced staffer if you aren't happy with the results. They should also give you basic advice about the regulations for being able to withdraw the money for a house, the tax issues, etc. The world is full of inadequate advice from people who should know better, so I would also visit your own bank, ask the same questions. Asking for advice more than once will help clarify it. Then consider seeing a CPA/ fee-paid financial planner for 1 hour to plan how you will buy your house.

Most consumer banks offer seminars in how to buy and finance a house; you can go to more than 1. They want to sell you a mortgage, so they're delighted to explain the process. Start going to open houses, let agents talk to you, make no commitments. The mortgage process is complicated and frustrating, it's not you, just make sure you have all your financial data available, shop carefully for a mortgage, again at historic low rates, and congratulations.
posted by theora55 at 11:02 AM on July 17, 2021

You may need more downpayment to get a house, but mortgage rates are lower than inflation/ return on investment from many types of investment. It's not a horrible idea to leave money in an IRA, earning, while paying interest, much of which will be deductible(after the standard deduction). This where the tax pro is a big help.
posted by theora55 at 11:08 AM on July 17, 2021