Over the next twenty years, younger generations are likely to inherit retirement accounts in large amounts. In fact, during those two decades, it is expected that Baby Boomers will transfer $30 trillion in wealth.
Some of those assets will be in retirement accounts like 401(k)s and Individual Retirement Accounts (IRA). While the younger generation is hopefully learning the mechanics of these accounts for their own savings, the particular rules for inheriting one opens the door to higher taxes and an eroding of the inherited assets.
IRAs provide a number of advantages, but operate under very strict rules. For those approaching or already in retirement it is important to understand these rules and how they apply to an inherited IRA. Your awareness will help shape your estate plan decision making. It’s also a good idea to discuss your intentions and hopes for any inheritance with those who will ultimately assume the assets.
If you are the beneficiary of someone else’s IRA when they pass on, you may have no idea how inherited IRAs work. Understanding how best to use those assets to avoid additional taxation is key to ensuring you make the most of your inheritance. Don’t let a lack of knowledge allow you to lose out.
Basic Rules Under the SECURE Act of 2019
There are two basic characteristics of traditional retirement accounts:
- The first is that at age 72, the owner must start taking Required Minimum Distributions (“RMDs”). These distributions are mandated so that the government can tax a portion of the balance. The distributions are meant to be “stretched” over the owner’s lifetime.
- The second is that investments grow inside the account tax free until they are withdrawn. Dividends, bond income, and realized capital gains are not taxed as they would be in a regular brokerage account.
Prior to the SECURE Act being passed by Congress in 2019, an individual could inherit a retirement account and “stretch” the required distributions over their lifetime. This stretch was beneficial, especially if the beneficiary is much younger, because they could allow the assets to continue to grow for a long period of time.
With the passage of the SECURE Act, beneficiaries can still open a Beneficiary IRA, but they now must withdraw the full balance over 10 years. Any assets not distributed by the end of the 10th year face a 50% penalty!
How Roth Rules Differ to a Traditional IRA
A person may also inherit a Roth retirement account. A Roth differs from a traditional IRA in that withdrawals later in life are not taxed as ordinary income. A Roth shares the tax-free growth inside the account, however.
Once you inherit a Roth retirement account, it is still subject to the 10-year withdrawal rule. Fortunately, the withdrawals would not be taxed.
What to Do When You Inherit an IRA
When you inherit an IRA account, you could withdraw the assets immediately, but the withdrawal is subject to income tax and it forfeits the tax-free growth inside the account. Instead, you can open a Beneficiary IRA and transfer the original owner’s IRA into the account.
This transfer of the inherited IRA does not trigger taxes and preserves the tax-free growth inside the account. The beneficiary, however, must withdraw and pay taxes on the full account value by the end of ten years whether they take out a portion every year or everything at the end of ten years.
There are a few classes of “eligible designated beneficiaries” who do not have to withdraw the balance over ten years.
- Minor child of the original owner
- Someone less than ten years younger than the original owner
- Someone who is disabled or chronically ill
(*leaving retirement assets to a disabled beneficiary who receives government benefits or to a special needs trust for their benefit can be problematic. It is best to consult a legal or financial professional.)
Let’s Look at Some Case Studies
To help make all this information a little easier to absorb, let’s look at how different individuals might handle an inherited traditional IRA.
Inheriting an IRA from Your Spouse
Sally is 67 years old and inherits $500,000 from her husband, Jerry, who was 69 when he passed away. Jerry had not started taking RMDs because he was not yet 72.
Sally chooses to withdraw the full $500,000 from the retirement account. She uses half to pay off the mortgage and puts the other half into her savings account for emergencies.
In 2021, this would mean she was pushed into the highest tax bracket, assuming she receives over ~$23,000 in Social Security and other income. As such, the inherited amount would be reduced by approximately 1/3 because it would be taxed as ordinary income when withdrawn.
Sally’s Medicare premiums would also increase because of the IRMAA adjustments, and she would be subject to additional taxes under the Medicare surtax.
As spouses do not have to set up the “beneficiary” type IRA, Sally opens a new traditional IRA in her name. This means she will not have to withdraw anything until she is 72 and will be able to “stretch” distributions over her lifetime.
In consultation with her financial advisor, Sally may decide to withdraw a portion to pay down her mortgage or support her spending in a tax-efficient way.
Inheriting an IRA from Your Father
Talia is 60 years old and is hoping to retire in the next 5 years. She inherits a $500,000 traditional IRA from her father.
Talia would owe a large amount of income tax on withdrawing the full account. The IRMAA adjustment would not affect her, but the Medicare surtax would.
Talia opens a beneficiary IRA and makes a non-taxable transfer from her father’s account to her new account. Over the next ten years, she withdraws a portion of the beneficiary IRA each year depending on tax position, withholds taxes, and transfers the funds to a long-term investment brokerage account.
These long-term investments provide her with more stability going into retirement. She also consults her financial advisor about asset allocation and what makes the most sense for this account which will be fully taxed as ordinary income upon withdrawal.
Inheriting a Roth IRA
Christian is 40 years old and inherited a $500,000 Roth IRA from his mother. There is no tax consequence to withdrawing the funds, but if he did, he would lose the tax deferred growth.
Working with his advisor, he positions this account for growth and will withdraw the money after ten years and will not owe income or capital gains taxes.
Making the Most of Your Inherited IRA
Inherited IRAs can have significant financial and tax implications. If you have recently become the beneficiary of an inherited IRA or are making your own estate plans, it’s a good idea to take some time and consult a fiduciary financial advisor for an analysis of your personal situation to determine what option is in your best interest.
Unless you truly need to do so, it generally does not make sense to withdraw the full balance of an inherited IRA. It is tempting to buy a new house or car but delaying gratification can make a huge difference in financial security later in life.
Even if you withdraw the money in ten years, it does not mean that you have to spend it! Consider investing the after-tax proceeds for your long-term goals, children’s college savings, or paying off debt (a form of savings in itself).
If you have any questions about the inherited IRA rules, or would like to learn more about how Abeona Wealth may be able to help you in this situation, we’d be happy to chat. Please reach out to schedule a free introductory consultation.