Inherited IRAs: How To Maximize Your Inheritance
Inheriting an individual retirement account isn’t like inheriting most other assets. With an inherited IRA, there are a lot of moving parts in terms of the type of IRA, the payout options, who the beneficiary is, and the tax impact. You will need to come up with the right strategy to maximize the value of the account and avoid taking a big tax hit.
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The rules on inherited IRAs can get complicated, so it’s important to familiarize yourself with them before making a decision on how to proceed. Keep reading to learn more.
Inherited IRA Basics
Inherited IRAs, also known as beneficiary IRAs, are accounts opened when someone inherits an IRA after the original owner’s death. Different rules apply depending on the type of IRA, which include traditional, Roth, rollover, SIMPLE and SEP IRAs.
The beneficiary of an inherited IRA is any person or entity specifically named by the deceased account owner, according to the IRS. The owner must designate the beneficiary under procedures established by the IRA or retirement plan.
The first thing to know as a beneficiary is that you can’t make additional contributions to the account like you would with an IRA you opened in your own name, according to a blog article on Charles Schwab. In most cases you can withdraw the money right away rather than wait until you hit age 59 ½, as you would with a regular IRA.
However, some of the same rules apply. For example, the funds in a traditional IRA remain tax-deferred. Here are a couple other things to keep in mind, according to the Schwab blog:
A designated beneficiary is typically required to liquidate the account by the end of the 10th year following the year the previous IRA owner died. If you don’t, you’ll face additional penalties.
There are exceptions to the above rule for certain eligible designated beneficiaries, but you’ll still face tax implications if funds remain in the account after the 10-year mark.
Payout Options
As previously reported by GOBankingRates, there are two basic ways to handle an inherited IRA: get a lump-sum payment or opt for a beneficiary IRA. Here’s what you need to know about each:
Lump Sum
When you opt for a lump-sum payout with an inherited IRA, it means you get the full value of the account in a single payment. Although this can provide a quick infusion of cash, it’s almost always the worst option if you want to maximize your IRA inheritance. That’s mainly because you’ll pay tax on the entire amount of your inheritance.
For example, if you’re in the 22% tax bracket and you inherit an IRA worth $50,000, you’ll owe $11,000 in taxes at the federal level alone – and that doesn’t even include state taxes. This means with a lump-sum payment, the value of your inherited IRA will already drop to $39,000 before other taxes and fees apply. You could take an even bigger tax hit if the inherited IRA pushes you into a higher tax bracket.
But there are situations when the lump-sum payout might be the best option. As financial guru Dave Ramsey noted in a 2023 blog, the lump sum might come in handy if you have high-interest, non-mortgage debt to pay down, or if you are still building an emergency fund. In addition, you can avoid the 10% early withdrawal penalty when taking a lump sum from an inherited IRA, even if you are under age 59 ½, when the penalty would normally apply.
Beneficiary IRA
With a beneficiary IRA, the account you inherit is transferred to a different IRA that lists you as the beneficiary This is the most tax-effective way to handle an inherited IRA because it shields you from the potentially big tax hit you would face with a lump-sum payout. You also can keep the funds in the account and continue getting tax-deferred growth until you have to withdraw the money.
Although you won’t pay an early withdrawal penalty for taking the money out of a beneficiary IRA before age 59 ½, you will pay tax on all distributions just as with any other traditional IRA. If you fail to get the money out in the required 10-year period, you’ll owe a 50% penalty on the amount you were supposed to withdraw. You will also have to pay tax on the money when you ultimately take it out.
If you inherit a Roth IRA, the same rules apply, but you won’t have to pay tax on any distributions.
Required Minimum Distributions
Beneficiaries of IRAs following the death of the account owner are subject to the normal required minimum distribution rules, according to the IRS. RMDs are mandatory withdrawals that go into effect when you reach age 72–or 73 if you reach age 72 after Dec. 31, 2022.
The factors that affect the RMD requirements for inherited retirement plan accounts and IRAs include the following:
Whether the account owner died after 2019 (the SECURE Act made changes to the RMDs for beneficiaries if the death of the account holder occurred after 2019).
The relationship of the beneficiary to the account owner (e.g. spouse or minor child) as well as certain other characteristics, such as being disabled or chronically ill.
Whether the original account owner died before or after their required “beginning date,” which is the first date the original account owner was required to begin taking RMDs.
Special Rules for Surviving Spouses
If you inherit a traditional, Rollover, SEP or SIMPLE IRA from a spouse, and you’re the sole beneficiary, you have a few different options based on whether your spouse died before or after their required beginning date to start taking RMDs. Determination of whether the spouse is the sole beneficiary is made by September 30 of the year following the year of the account holder’s death.
Typically, those who inherit an IRA from a spouse transfer the funds to their own IRA, according to Schwab. If the original account holder did not take an RMD in the year of death and they were required to, an RMD must be taken from the account by December 31 of the year the original account holder died.
Another special provision for spousal beneficiaries is that you can take distributions from the IRA over the course of your life expectancy, as determined by IRS tables.
Here’s an example: You are expected to inherit a $200,000 IRA and IRS states you have a 20-year life expectancy. You must withdraw $10,000 or less in that first year. Then, each following year, you’ll need to figure out how much to withdraw. Do this by dividing the amount left in your account by your life expectancy in years.
Inheriting vs. Assuming an IRA
In some cases you can assume an IRA, which is not the same as inheriting one. Here are some of the differences, according to Vanguard:
Assume: This happens when an IRA is transferred into your name. When the transfer is complete, you’ll follow the same IRA rules you normally would, including rules governing contributions, distributions and RMDs.
Inherit: The main difference with an inherited IRA has to do with IRS rules. For example, you have more flexibility about when you choose to begin distributions and how you decide to take them.
Other Tips to Maximize Your IRA Inheritance
In addition to weighing the pros and cons of lump-sum payouts vs. beneficiary IRAs, here are some other ways to maximize your IRA inheritance:
Take Your Time
One good strategy when it comes to inherited IRAs is to choose the longest withdrawal timetable you are legally allowed to, according to Motley Fool Wealth Management MFWM. If your beneficiary is not your spouse, the length of time to empty your account can be up to 10 years. This strategy allows the IRA to continue gaining in value over time.
“For a non-spouse [beneficiary], it would be best to align the distributions with your expected income for the next 10 years,” Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, told GBR in a conversation last year. “Either space it out, or try to find years where you are earning less than normal to take the distributions.”
For spouse beneficiaries, Chisholm recommends waiting until RMDs begin before taking withdrawals.
Liquidate Any Illiquid Assets as Soon as Possible
If the account you inherit holds an illiquid asset, you should plan on liquidating the asset “well before” the end of the 10-year period whenever possible, Chisholm said. Otherwise, it can complicate the distributions.
Hire an Expert to Help Plan Your Taxes
Because there are so many different scenarios at play when it comes to inherited IRAs — and so many different tax consequences – it’s a good idea to consult with a tax professional before making any tax decisions. Don’t depend on your own judgement if you don’t have expertise in tax planning.
Offset the Tax Impact
In some cases, you might be able to offset additional taxes on inherited IRA withdrawals by increasing contributions to your own retirement account, according to MFWM. You might also be able to contribute to a traditional IRA of your own if your income qualifies, or a SEP-IRA or Simple IRA if you are self-employed.
The best place to put any distributions from an inherited IRA is a traditional retirement account, according to Chisholm.
“Use this extra money to contribute to a traditional retirement account to help reduce your taxable income,” he said.
Review the IRA’s Investments
Although you can’t make contributions to an inherited IRA, and it’s best to wait as long as possible to make withdrawals, that doesn’t mean you should leave it alone entirely. To maximize your inherited IRA you should review its investments to see how they are performing and determine if they have the right mix of assets to deliver the best returns.
The first step is to determine your risk tolerance and retirement goals. For example, if you are past age 50 when you inherit the IRA, you probably want to tilt the IRA’s investments in favor of lower-risks assets like CDs, Treasury bills, savings bonds and money market funds. If you are young and have more time to recover from market slumps, you can lean more toward higher-risk investments such as stocks, mutual funds and exchange-traded funds.
Consider Taking a Disclaimer
If you don’t need the money from an inherited IRA and would rather not have it in your portfolio, you don’t have to accept it. In this case, you can “disclaim” the IRA and pass it along to another beneficiary. This strategy lets you avoid the potential tax consequences while helping maximize the IRA’s value for those who can use it.
As MFWM noted, you might decide to disclaim the IRA if the deceased account owner named you the beneficiary and your children the contingent beneficiaries. When you opt to disclaim the IRA, it will automatically pass to your children. Here are some rules to keep in mind:
The disclaimer must be done in writing within nine months of the original owner’s death.
You cannot attach any conditions to the disclaimer.
You can’t choose who gets the disclaimed IRA. Instead, it will follow the contingent beneficiaries of the IRA of the original owner.
You have to disclaim an inherited IRA before accepting it
If you do opt to disclaim the IRA, consult with a tax or estate planning attorney to make sure all of the rules are properly followed.
Final Take
Maximizing your inherited IRA depends on numerous factors, including your age, financial situation and relationship to the loved one or the deceased, along with the type of IRA and the investments it holds. The ideal strategy is to forego a lump-sum payment and hold the beneficiary IRA as long as possible to minimize the tax impact and ensure the highest return.
But you should also keep in mind that it’s not a one-size-fits-all process. If you have heavy debts to pay off, or have not yet established an emergency fund, then taking a lump-sum payout might be the best way to maximize an inherited IRA. If you have the means to do so, hire a professional financial and tax expert to help you develop the best strategy.
FAQ
Here are answers to some common questions about inherited IRAs.
When do I have to withdraw the money from an inherited IRA?
You typically have 10 years from the death of the original owner to cash out all of the assets within the inherited IRA.
Can I cash out an inherited IRA?
Yes, you can cash out an inherited IRA without the usual early withdrawal penalties by taking a lump-sum payout. However, you'll have to pay taxes.
Will I owe taxes on an inherited IRA?
If you inherit a traditional IRA, you will pay the usual taxes when you begin withdrawing the money. With an inherited Roth IRA, no taxes need to be paid on withdrawals.
This article originally appeared on GOBankingRates.com: Inherited IRAs: How To Maximize Your Inheritance
