Understanding the Dynamics of Inheriting an IRA

Inheriting an Individual Retirement Account (IRA) can be a significant financial event, often carrying both emotional and practical considerations. How you handle inheriting IRA can have long-term implications for your financial future.

Recently, the landscape of estate planning concerning IRAs has experienced significant shifts, particularly for traditional IRAs with substantial assets, potentially resulting in a hefty tax liability, substantially diminishing the inheritance's value. Understanding the options available to you is crucial to making informed decisions and maximizing the value of your inherited assets. Let’s delve into what you need to know.

Before we do that, let’s level-set with some definitions and ground rules:

• Eligible Designated Beneficiary. This is a spouse or minor child of the deceased/original account holder; disabled or chronically ill individual; an individual who is not more than 10 years younger than the original account owner.
• Designated Beneficiary. Any individual designated as the beneficiary of an IRA who does not fit any of the above categories.
• Required Minimum Distributions (RMDs) - Beneficiaries of IRA accounts are required to take distributions from the account, known as required minimum distributions (RMDs).
• 10-Year Rule – Based on the type of beneficiary, this would require the entire balance of the inherited IRA account to be distributed or withdrawn within 10 years of the death of the original owner. For a minor child, the 10-year rule kicks in once they reach age 21.

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The SECURE Act and Inherited IRAs

With the passing of the SECURE Act in 2019 (SECURE Act 1.0), the rules for inheriting an IRA changed drastically. These new rules impact individuals who inherit a retirement account from someone who passed away in 2020 or later. Generally, individuals who inherited retirement accounts in 2019 or before will fall under the old rules—however, any successor beneficiary who inherits a retirement account in 2020 or after will be covered by the new rules.

Before passage of the SECURE Act, beneficiaries of inherited IRAs could ‘stretch’ their distributions over their life expectancy – this was called a……you guessed it……Stretch IRA. This, in most cases, reduced their RMDs and the associated tax burden.?However, the Stretch IRA is no longer permitted for all beneficiaries when the original account holder passed after Dec. 31, 2019.

For the purpose of this article, we will focus on the new rules under the SECURE Act, which are based primarily on the type of beneficiary you are and your relationship to the original account owner. (For example, the spouse of the account owner has more options than a non-spouse beneficiary.)

Now let’s take a look at the options each type of beneficiary has.

Eligible Designated Beneficiary: Spouse

When inheriting an IRA, the surviving spouse has the following options:

1. Treat the inherited IRA as his/her own. If the IRA is a traditional IRA and the surviving spouse is younger than 73, but the deceased spouse had begun taking their RMDs, treating the inherited IRA as their own allows them to delay future RMDs until they reach age 73. This option allows the IRA to continue to grow tax-deferred until RMDs commence. Note, if the deceased spouse had not taken their RMD for the current year, the surviving spouse will need to take that distribution.
2. Stretch IRA based on their life expectancy. Opting for a Stretch IRA based on the surviving spouse's life expectancy proves advantageous, particularly for those under 59.5, allowing RMDs to stretch over their lifespan and dodging penalties on distributions.
3. Stretch IRA based on original owner's beginning date of RMDs. This can be more tax-advantageous if the original owner was younger.

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Eligible Designated Beneficiary: Non-Spouse

Options for a beneficiary who is not the spouse of the deceased account owner but still meet the requirements listed above may:

1. Stretch IRA based on their life expectancy.
2. Stretch IRA based on the original owner’s life expectancy.
3. Follow the 10-year rule. Empty the entire account by the end of the 10th year following the year of the original owner's death.

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Designated Beneficiary

The only option now available to a designated beneficiary (someone who is not an eligible designated beneficiary) is to follow the 10-year rule.

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Disclaiming an IRA

A less commonly considered alternative within the initial estate plan involves the act of disclaiming, or declining, all or a portion of the IRA by the surviving spouse or other inheritors. In this scenario, the assets would then transfer to an alternate beneficiary, which could include another family member, or default to the estate if no alternative beneficiaries are designated. Opting to disclaim the IRA might be a prudent choice for individuals who are financially stable and wish to circumvent potential tax implications stemming from the added income.

Consider a scenario where the surviving spouse deems the inherited assets unnecessary and prefers their allocation to other beneficiaries, such as children or grandchildren. Similarly, concerns may arise regarding estate tax implications due to the addition of these IRA assets, particularly pertinent with the imminent sunset of the current higher estate tax exemption levels post-2025.

Please note: You will need to disclaim the account within nine months of the original owner's death and before taking possession of any assets. Additionally, disclaiming assets still may have implications and trigger ramifications for income taxes, inheritance taxes and issues surrounding other primary or secondary beneficiaries.

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Special Considerations

Let’s look at a few special situations that may be relevant.

• Roth IRA vs. Traditional IRA: Inherited Roth IRAs have different tax implications than traditional IRAs. Roth IRA distributions are generally tax-free, while traditional IRA distributions are subject to income tax. Understanding the type of IRA inherited is crucial for tax planning and can impact what method you follow for taking the RMDs.
• Estate Planning: We’ve listed several considerations, however, there are of course many more situations and scenarios that would dictate different planning strategies – and the rules and regulations can certainly be complex. Additionally, inheriting assets means you now have more assets to pass on to your beneficiaries which, may in turn, substantiate a need to update your own estate plan.
• Charitable Giving: In some cases, beneficiaries may choose to donate all or a portion of the inherited IRA to charity. This can provide tax benefits while supporting charitable causes.

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Bottom Line

Given the complexity of these new rules, a tax, estate, or financial advisor can provide guidance on your options, explain requirements, and help you implement a tax-efficient withdrawal strategy if you inherit a retirement account. Not all options are available to all beneficiaries. And not all options are the right option.

Consulting with a financial professional can provide personalized guidance tailored to your specific situation, ensuring that you make the most of your inheritance while minimizing tax implications and maximizing long-term growth potential.

Proper planning – both prior to, and upon inheriting assets – cannot be understated. And it’s also a good time for you to review your own beneficiaries and make sure your accounts are set up to carry out your wishes.

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Sources: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary

#inheritedIRA #retirementplanning #financialplanning #feeonlyadvisor #CFP

Bill Davis is a CERTIFIED FINANCIAL PLANNER? and Managing Partner with Vericrest Private Wealth LLC, a financial advisory firm in Newtown, Pennsylvania. We provide fee-only, objective advice to our clients.

Vericrest Private Wealth LLC ("Vericrest") is an SEC registered investment advisory firm.??The information provided herein should not be?construed as personalized investment advice and should not be considered as a solicitation to buy or sell any security or investment advisory service.?Past performance is no guarantee of future results, and there is no guarantee that future investments will be profitable.? ?While we believe that third party information provided is accurate, Vericrest does not guarantee or otherwise warrant such information. ?For more information please contact Vericrest or refer to the Investment Adviser Public Disclosure website?(www.adviserinfo.sec.gov) to review important disclosures about our firm.