Over the next twenty-five years, Americans are expected to inherit an astonishing $72.6 trillion. Yes, that is TRILLION with a T. Many of these inheritances will be delivered to beneficiaries of IRAs, 401(k) or other retirement accounts. How you handle your inherited IRA can greatly increase or decrease the taxes due and, ultimately, the value of your inheritance.
With the 2017 tax overhaul, which doubled the size of an estate that can be passed estate tax-free to heirs. While it is true that far inheritances will be subject to estate taxes, assets held in retirement accounts will still be subject to income taxes when funds are withdrawn.
The larger the inherited IRA (or another retirement account), the more valuable having a proactive plan to minimize taxes will be to you. I’m a financial advisor in Los Angeles, where making a mistake with your inherited IRA could take the taxes due from near zero percent to above 50% (counting both state and federal taxes). Put another way, not planning to minimize the taxes on your inheritance could cut its value in half.
For ease of reading, I will just use Inherited IRA- but the concept applies whether you are inheriting a 401(k), 403(b) or any other -pre-tax retirement account.
What To Do As The Beneficiary Of An IRA
There are two main options to go when you Inherit an IRA. You can take all of the money out right away and just deal with the enormous tax bill you might be creating. Or you can rollover the funds to an Inherited IRA (often called a Beneficiary IRA) or rollover the funds into an IRA in your own name if you are inheriting the IRA from a deceased spouse. This will allow you to strategize to pay the least amount of taxes on your Inherited IRA income over time.
On the bright side, there is no 10% early withdrawal penalty for withdrawals prior to age 59.5 when pulling money from an Inherited IRA. Unfortunately, you will still be liable for income taxes on withdrawals you make from your Inherited IRA. If the Inherited IRA is a large account, you could find yourself in a much higher tax bracket when making a substantial withdrawal.
Non-Spouse Beneficiaries Inherited IRA Deadlines
When you inherited the IRA will also play a role in your Required Minimum Distributions. You will need to know if you inherited your IRA before or after January 1, 2020. Your RMD requirements will depend on whether you inherited your IRA before or after this date.
When mourning the loss of a loved one, taxes and tax deadlines are likely not top of mine. However, ignoring them could be a costly mistake you would regret later. For those of your reading this who want to maximize the value of your inheritance and minimize the taxes you owe on it, you must be aware of the various tax dates and deadlines you must adhere to.
Assuming you Inherited an IRA before January 1, 2020, or are in on the exception categories listed below, these are your RMD rules.
You must make Required minimum distributions (RMDs) from your inherited account by December 31 of the year after the IRA or 401(k) owner passed. The good news here is this does give you some time to get professional tax planning guidance in regards to your inheritance. RMD withdrawals would be based on your own life expectancy each year, starting no later than December 31 of the year after your loved one passed away.
You will have to follow different RMD rules if you are not a surviving spouse or meet one of the following exceptions to the new RMD rules in the SECURE ACT.
New SECURE Act Rules For Inherited IRAs
You may or may not have heard of the Setting Every Community Up For Retirement Enhance Act of 2019, more commonly known as the Secure. Most famously, this pushed the IRA RMD beginning date from 70.5 back to 72 years old.
It also made some dramatic changes to the RMD rules for Inherited IRA. The Secure Act requires that the entire balance of an Inherited IRA be withdrawn within ten years of the death of the original owner. This applies to all IRA inheritances after January 1, 2020. Keep in mind this is based on the date of death, not when you actually received the IRA funds. This new ten-year Rule will apply regardless of the age of the deceased and regardless of whether or not they had begun taking RMDs themselves.
Important Exceptions to the 10-Year Rule
This is where working with a tax planning expert can be extremely valuable: there are several exceptions to the ten years rule for several types of beneficiaries. There are exceptions for a surviving spouse, a disabled or chronically ill person, a child who has not yet reached the age of majority, and lastly, a beneficiary who is not more than ten years younger than the deceased.
If you are a beneficiary and fit into one of these exception categories, you will not be forced to completely withdraw all the Inherited IRA funds based on the ten-year Rule. (If you are a surviving spouse, see “Inherited IRA Rules For Spouses” below). The other exception categories (children, disabled, or beneficiaries not more than ten years younger than the deceased) will still be allowed to take RMDs based on their own life expectancy.
Inherited IRA Rules For Spouses
It is very common to leave your retirement account to your spouse. Many states even require this beneficiary election.
When a spouse inherits an IRA, they have a valuable third option unavailable to non-spouse IRA beneficiaries. Widows and widowers can rollover the Inherited IRA into their own retirement account in their name. This allows them to skip the setting up of a separate Inherited IRA and allows them to push off taking RMDs until they reach the age of 72.
The main negative to that Inherited IRA strategy is that withdrawals taken before 59 ½ will be subject to the 10% early withdrawal penalty. That is not a big issue if you do not plan or expect to touch the money or if you are already above this age.
If you are the surviving spouses anticipate needing some of the money from your Inherited IRA before 59 ½, they may want to consider moving some of the inheritance into an Inherited IRA to avoid the 10% early withdrawal penalty on money taken from this specific account. Then move the rest into an IRA in your own name.
Rule If the Deceased Was Already Taking RMDs
If the deceased original IRA owner was taking RMDs, the beneficiary could decide whether to continue the annual withdrawals based on the decedent’s RMD schedule or their own life expectancy. Generally speaking, if you are older than the deceased, you would want to use their RMD schedule. On the flip side, if you are younger, you would likely want to use your age to determine RMD amounts.
ROTH IRA Inheritance Rule
The rules are different for owning and contributing to a Roth IRA versus a Traditional IRA or 401(k) plan. You shouldn’t be surprised that there are also different rules when you Inherit a ROTH IRA. A Roth IRA can typically be inherited tax-free. But unlike a ROTH IRA in your own name, you will not be allowed to keep money in an inherited Roth IRA forever. Non-spouse beneficiaries will be required to make distributions each year based on their own life expectancy. That requirement starts the year after the original owner’s passing.
Spousal beneficiaries have the option to rollover the inherited Roth IRA into a Roth IRA account in their own names. They will not be forced to take RMDs. They will also have the option to just pull all the money out tax-free.
That being said, you will be better off leaving the money in the Roth IRA, growing tax-free, versus outside in the taxable environment.
See IRS Publication 590, “Individual Retirement Arrangements,” for more information about the fine print, as well as the life expectancy table for required withdrawals.
Your trusted financial planner can help guide you through this difficult time. If they offer tax planning (most advisors don’t), they can also help you make the most of your inheritance. They are guiding you to options to minimize taxes on your inheritance. If nothing else, a trusted financial planner can help take some of the stress out of all the choices you are forced to make when you least want to think about anything financial. Simply checking the wrong box on a form could cost you a large percentage of your inheritance—no fun in that.