Inherited an IRA? Before You Make a Tax Decision, Read This.

It’s easy to get tripped up by a variety of tax questions. Here’s your guide.

Before we get to today’s topic—how taxes shape your financial planning—you might have seen the frightening headlines about Social Security running out of money, and soon. Join me for my first-ever Substack Live on Wednesday, July 15, at noon ET, where economist and Social Security expert Larry Kotlikoff and I will dive into what this means for the public—and retirees in particular. You can add it to your calendar here and watch from your Substack account. Drop your questions in this post’s comments, and we’ll address them live.

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I was just asked this question by a close friend who had inherited an IRA from a parent. She wanted to know, “Am I going to get hammered in taxes?”

It’s a smart question because it’s one of the biggest misconceptions about taxes.

Most people know inherited IRAs come with tax consequences. And because most non-spouse beneficiaries now have to empty an inherited IRA within 10 years, the question isn’t whether they’ll pay taxes. It’s when, and how much?

It’s so easy to get tripped up. You might assume that taking money out of an inherited IRA will push you into the next higher tax bracket, and then just like that… all of your income will now be taxed at that higher rate.

It doesn’t work like that. Federal income taxes are marginal. That’s the technical term, but the concept is pretty simple. Only those dollars that cross into the next tax bracket are taxed at the higher rate. Everything below that threshold continues to be taxed at the lower rates.

Think of it this way. If you’re standing at the shoreline and dip your big toe in the ocean, your whole body isn’t suddenly submerged. It’s just your toe that’s wet. That’s how tax brackets work.

If this sounds surprising, just know more than half of Americans didn’t understand how marginal tax rates work. According to the 2024 Tax Foundation survey, a third believed all of their income would be taxed at that higher rate. That’s the misconception that leads people to make expensive financial decisions.

Why Your Marginal Tax Rate Matters

It sounds like an in-the-weeds distinction but it’s not. Once you know only the dollars above the threshold are taxed at the higher rate, and the rest of your income doesn’t move up with them, it changes the way you think about tax planning.

I’ve seen people put off taking distributions they actually needed because they were afraid of moving into the next tax bracket. The irony is that waiting too long can leave them taking much larger withdrawals later in that 10-year window, potentially pushing them into a higher bracket than they would have reached by spreading those withdrawals out more thoughtfully.

The same misunderstanding shows up with Roth conversions. People sometimes avoid the conversion because they don’t want to pay taxes today, without realizing that paying a little tax now can sometimes save a great deal more later. The issue isn’t the event that triggers the next tax bracket—whether it’s inheriting an IRA, taking a retirement distribution, or doing a Roth conversion. The issue is understanding what actually happens when you get there.

That’s why I encourage people to stop worrying about “How do I avoid the next tax bracket?” The most useful question is, “How much room do I have left in my current tax bracket?”

Now you can start planning.

That simple shift in your mindset can change decisions you might otherwise make based on fear. Now you’re making decisions based on facts.

This is why I carefully vet independent, fee-only financial advisors for tax planning expertise in addition to their investment expertise. The best advisors don’t just react to a tax bill after the fact. They help clients make better decisions before the tax is ever triggered.

That’s the kind of planning lens Marianela Collado, CPA/PFS, CFP®, an advisor in Wealthramp’s network, is using. She reminds us, “Making money is great, but more important is how much of that money you keep.”

That’s exactly the point. Good tax planning isn’t as much about avoiding tax brackets as it is understanding how they work. Then you can use them to your advantage.

P.S. I spoke to AARP recently about the benefits of a one-time financial plan. Check it out here.