You know, some of the best lessons I learned in my adult life were from my undergraduate days at Massachusetts Maritime Academy. One of the classes we had to take freshman year was a course in navigation. Even though I finished my studies in engineering, studying navigation in those early days taught me to approach problems by first determining what position I was in and then determining what direction I needed to go. It wasn’t just applicable to being on the water though, and I use many of the problem-solving skills of navigation in my financial advisory practice to this day.
In my practice, I have found that some of the more difficult things to navigate when building out retirement systems involve taxes and IRS rules and regulations. Due to recent changes by Congress, inheriting an IRA becomes a bit more complicated. With the changes, more attention must be given to assessing your present position and charting the right course to your destination, without losing too much precious cargo to taxes along the way. So, this week with our time together, I’d like to review some of the challenges an Inherited IRA poses and ways to tackle them.
For starters, if properly administered, we know that IRAs, whether a traditional or a Roth, pass upon the owner’s death to their named beneficiary.
A Roth IRA is relatively simple. Since a Roth IRA has been funded with after tax dollars, generally speaking, as long as it has been at least five years since the owner funded a Roth IRA, the proceeds can be withdrawn tax free by the heir. If the Roth IRA is less than five years old, generally speaking, any investment gain included in a distribution would be taxable at the heir’s marginal tax rate. With a traditional IRA, distributions would be taxed at the heir’s marginal tax rate, except for amounts that represent after-tax amounts which would be tax-free.
When a Roth or Traditional IRA is inherited by a spouse, the options are complex and involves different choices. The decisions must be based the spouses ages, their other IRAs and qualified accounts, and if they’ve already started taking Required Minimum Distributions (RMDs). The flexibility for a spouse inheriting an IRA allows them to practice tax efficiency.
A surviving spouse inheriting a traditional IRA has a few options and can chose between becoming the owner of the inherited IRA, become the owner and roll the IRA into their own IRA or a qualified employer plan, or acting as the beneficiary of the plan. The spouse’s options for a Roth IRA are the same, except that a Roth IRA cannot be rolled over to a qualified plan.
Whether to act as an owner or beneficiary of inherited IRA will often be dictated by whichever scenario creates the longest life expectancy in determining RMDs, and whether distributions would be subject to the 10% early distribution penalty. If the spouse is under age 59 ½ and plan to take distributions before reaching age 59 ½, keeping the amount in an inherited IRA avoids the 10% early distribution penalty. Some of the decision will be driven by whether the deceased spouse has already started taking RMDs. RMDs for a traditional must begin for the year that the owner reaches the age of 72 . If the surviving spouse is younger, they will typically want to become owner of the IRA since it can serve to delay the necessary RMDs until they reach age 72. In addition, this also allows the surviving spouse to roll all or part of the inherited IRA into their own IRA or qualified employer plan account. In cases where the surviving spouse is older and RMDs haven’t started, the surviving spouse can act as a spousal beneficiary and delay RMDs until the original owner would have attained the age of 72. RMDs do not apply to Roth IRA owners.
Non-Spousal Roth and traditional IRA beneficiaries who inherit the IRAs in 2020 or after have a maximum of ten years from the death of the original owner to withdraw the entire amount of the inherited Roth or traditional IRA. If the heir is under age 59-½ they won’t be subject to the usual 10% penalty, but still owe income tax on withdrawals of pre-tax amounts. The only exceptions to this 10-year rule beside those already described for spouses are for beneficiaries who are minor children of the IRA owner, chronically ill or disabled persons, or those that are not more than 10 years younger than the IRA owner.
Now, there are other issues to consider and possible pitfalls to avoid as well. For example, it’s important to remember that an RMD failure to take an RMD can result in a 50% tax penalty, so don’t play chicken with the IRS.
Folks, I know I got a bit technical this week. But it is critical to properly title your inherited IRA. The new ownership should still show the original account owner with you as the beneficiary. Also, while a trust can be the beneficiary of an IRA, it requires very careful and precise wording to avoid problems determining the ultimate qualified beneficiaries. You should work with an attorney experienced in drafting language related to leaving IRAs to trusts.
Inheriting an IRA is a gift, but it requires understanding the complexities of the various rules. If you have concerns, consult a qualified financial adviser. Because proper navigation will keep you off the rocks and away from pirates – or in this case, the IRS.
So as always – be vigilant and stay alert, 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, and Mansfield. Jeff can be reached at jeff@cutterfinancialgroup.com.
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