An inheritance can be a wonderful thing. An unexpected blessing that can be a sizeable addition to your bank account. Unfortunately, an inheritance almost always comes with the loss of a loved one, so it’s often received with mixed feelings, including feeling confused or even guilty. In addition, the passing of property and assets doesn’t always go as expected or planned, so this is a time when you may want take a step back and take a deep breath before you make any big decisions. And when you’re ready, you should know your options for your inheritance so that you can make the best use of it and avoid making a costly mistake.
I was recently reminded of this after meeting with Brian and Mary, as I’ll call them, a couple from Centerville who recently came into my office. They’re great folks: a couple in their 50s with an adult son, also Brian – working as a general contractor right here on Cape Cod, just like his old man. Brian and Mary are hard-working folks who have lived modestly. Brian recently inherited IRAs and wants to make sure it is appropriately invested and accounted.
Brian inherited two IRAs – a traditional and a Roth – with a combined value of about $400,000 from his beloved Aunt Jean who passed earlier this year. It’s the single most significant sum Brian and Mary have seen in decades, and they want to honor their aunt by making the right decision about how to manage the inheritance. While they want this inheritance to work for them as effectively as possible, they also want to minimize the tax headache that could be imposed by this newfound wealth.
With baby boomers retiring in record numbers, the next generation is expected to inherit trillions – yes, trillions – of dollars in the coming 20-30 years. This week let’s take a look at the rules around inherited IRAs to better understand how inherited IRA works.
When you inherit an IRA, how you can withdraw the money depends on a few factors – starting with your relationship to the deceased. The IRS grants spouse beneficiaries a special exception. Spouses may transfer part or all of the inherited IRA assets to their own IRA and may continue to contribute to the IRA (as long as they’re eligible to do so). Unfortunately, that’s not the case here with Brian’s inheritance.
Outside of spouses, IRA inheritors are expected to either take a lump-sum distribution or take Required Minimum Distributions (RMDs) until the funds are exhausted. While I often advise folks against taking the lump-sum distribution, it is tempting to Brian because he wants to make home improvements and to pay down debt. A lump-sum distribution would provide the couple with a considerable amount of cash. But it will also move them into a much higher tax bracket.
Because Brian inherited the IRAs from his aunt, he’ll first have to transfer those assets into new IRAs -formally identified as an inherited/beneficiary IRAs (traditional beneficiary IRA for the traditional IRA and Roth beneficiary IRA for the Roth IRA) in his and his aunts name. Simply putting the amounts in IRAs that are only in his name could cause them to be treated as distributions, with all the funds reported to the IRS as distributions and any pre-tax amount taxable to him for the year. Brian may not contribute to the new accounts, though they can continue to grow tax-deferred.
With lump-sum distributions off the table, Brian must take RMDs until the funds in the IRAs are depleted. Brian has two options when it comes to RMDs. He can follow the “Five-Year Rule,” which requires him to take distributions within five years of his aunt’s death. That would enable him to postpone distributions until December 31, 2024, at the latest.
Another strategy for Brian and Mary to consider is taking RMDs over his life expectancy. Using the life expectancy strategy will provide Brian with annual income until the account is depleted. He’ll be able to count on that for years to come, and it’s something Brian and Mary can factor into their retirement plans now.
His aunt was in her late 60s when she passed, so she was not required to take RMDs yet. If Brian’s aunt had reached the age for starting RMDs at the time of her death– April 1 after her 70 ½ birthday year – the IRS would require him to use the longer of his life expectancy or his aunt’s.
This is what we refer to as a “Stretch IRA” strategy. IRAs are sometimes bequeathed to the youngest relative in the family. The RMDs are then smaller and can be “stretched” over a more extended period of time.
Distributions from inherited IRAs come with their own set of tax implications, so let’s start with the Roth IRA. As you may know, Roth IRAs are funded with post-tax income. You can take distributions when you’re eligible without paying income tax on those distributions.
Brian’s aunt opened the Roth IRA 10 years ago. That means he can take distributions at any time without incurring taxes. If his aunt had opened the Roth IRA less than five years before her death, he would owe taxes on distributions of earnings taken before the Roth IRA ages five years. But, since the earnings would be the last amount distributed, Brian would likely reach the five-year mark before getting to the earnings.
Withdrawals from a traditional IRA, whether one’s own or inherited, are taxable at the beneficiary’s own income tax rate rather than the original account holder’s. The bulk of the value of the IRAs Brian inherited come from the traditional IRA, so he and Mary will need to consider the tax implications of that additional annual income to see how it affects their tax bracket.
If Brian’s aunt had been required to take RMDs for herself, but did not do so, he’d be required to take that RMD on her behalf (reported under his social security number), and he’d be required to include that amount in his income. Again, that’s not the case here, but important for inheritors of IRAs to know.
Brian is lucky here, as it turns out. He may take distributions in whole or part from his aunt’s Roth IRA to make at least some of those home improvements he’s been thinking about, without worrying about paying more in taxes. While distributions from the traditional IRA will change his and Mary’s tax status, he’s young enough that the IRS will give him a good long time to spend down the inherited IRA using his life expectancy to calculate the RMDs. What’s more, it’s regular income he’ll be able to count on for many years to come.
Even though Brian isn’t 59 ½ yet, the pre-59 ½ 10% early distribution penalty would not apply, because the distributions would be due to the death of the IRA owner.
Folks, having a plan to spend your inherited IRA should only be one component of broader retirement system. This system should help prepare you for the quality of life and level of independence you want in retirement. Your system must have in place a Downside Risk Mitigation Strategy (DRMS). A proven and successful DRMS can allow you to benefit from the market’s upside while protecting your investments during periods of market turbulence. With everything going on in the markets these days, protecting yourself from downside risk is crucial. Work closely with a qualified specialist to make sure you’re making the right decision for how to invest your wealth – whether it’s inherited or earned.
It’s all part of being alert and staying vigilant, because you deserve more.
Have a great week!
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC
Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield & Southlake, TX. Jeff can be reached at email@example.com.
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