What Is The Best Thing To Do With An Inherited IRA?
Monday, March 4th 2024
An Individual Retirement Account (IRA) inheritance might seem like a financial windfall, but inheritors must understand its nuances – including tax implications and strategic considerations – prior to accepting it as their inheritance. Determining an appropriate path forward depends heavily upon each inheritor’s unique circumstances including current finances, tax bracket, and long-term goals.
Understanding an Inherited IRA
An Individual Retirement Account, or IRA, allows individuals to save for retirement tax advantageously. When account owners pass away, their inherited IRA may pass to one or more beneficiaries; such individuals could include spouses, non-spouse individuals such as children or grandchildren, trusts, or charities.
Rules surrounding inherited IRAs can be complex and vary based on both their type (Traditional, Roth, SEP or SIMPLE), and who the beneficiary is related to in terms of family relations. Furthermore, passage of the Setting Every Community Up for Retirement Enhancement Act in 2019 (1) significantly altered these regulations for non-spouse beneficiaries inheriting these accounts.
One simple solution for surviving spouses who inherit an IRA is treating it like your own by either designating yourself as the account holder or rolling over its funds into their own IRA or qualified employer plan. This gives more flexibility, since RMDs (required minimum distributions, 2) won’t need to be met until reaching age 72 with Traditional IRAs.
However, if a surviving spouse is under 59 1/2 and withdrawing funds before age 59 1/2 is subject to income taxes rather than incurring an early withdrawal penalty, an inherited IRA might be worth keeping as this avoids paying any early withdrawal penalties of 10% early withdrawal penalty and income taxes will still apply as expected.
The 10-Year Rule
Under the SECURE Act, non-spouse beneficiaries have 10 calendar years from their original account holder’s death to distribute any balance remaining from an inherited IRA account they’ve inherited – though there are no required minimum distributions during this timeframe – without incurring RMD penalties each year. They also enjoy some flexibility regarding when and how much to withdraw each year.
This rule holds regardless of whether an inherited IRA is Traditional or Roth; however, tax consequences differ accordingly: withdrawals from an inherited Traditional IRA count towards your taxable income while withdrawals from an inherited Roth IRA usually are free from taxes.
The 10-year rule presents an invaluable opportunity for tax planning. Beneficiaries can time their distributions with years when they anticipate being in lower tax brackets to minimize how much in taxes is owed to Uncle Sam.
Life Expectancy Method
Before the SECURE Act was enacted, non-spouse beneficiaries could stretch an inherited IRA over their life expectancies by only taking RMDs depending on age – this allowed fund within it to continue growing tax-deferred for decades!
Under the SECURE Act, this option has largely been discontinued with exception to an under a small group known as ‘eligible designated beneficiaries’ who include disabled individuals, chronically ill individuals, those within the 10 years younger age bracket than deceased individuals and certain minor children (until they reach majority age).
Lump Sum Distribution
Beneficiaries who inherit an IRA should consider taking a lump sum distribution, but be warned this could incur significant tax bills in the year of withdrawal (with certain Roth IRAs where qualified distributions may be tax-free). This option should also be pursued when taking care of estate matters involving spouses who inherit large sums in inheritance taxation issues but will increase tax bills dramatically at withdrawal time.
Although taking a lump sum distribution could provide immediate liquidity, it could cause them to be placed in more tax brackets, resulting in higher tax burdens and removing the potential for future growth in the IRA tax-deferred or tax-free
Considerations When Deciding How to Utilize Inherited IRA
- Financial needs: If your immediate financial needs require it, take into consideration any tax implications of taking large distributions out of an inherited IRA account.
- Tax bracket: Considerations should include both your current and projected future tax bracket when making decisions regarding distributions from retirement accounts. If you anticipate being in a higher bracket in future, larger distributions might make sense now; otherwise, if lower tax brackets appear ahead, defer distributions until then.
- Age and life expectancy: Younger beneficiaries have longer to let investments grow before needing distributions; delaying payments to them for as long as possible could prove advantageous; those already taking RMDs from their retirement accounts, however, may prefer speeding up distributions so as to not add another RMD obligation later.
- Investment opportunities: If there are more favorable investment options outside the inherited IRA, taking a lump sum distribution and investing it elsewhere might make more sense; but before doing so it’s essential that you compare their potential after-tax return against that provided by tax-advantaged growth in an inherited IRA.
- Legacy goals: When leaving behind an inheritance for your heirs, deferring distributions as long as possible may be your optimal strategy in maximizing tax-advantaged growth of any inherited IRAs you create as legacies.
Your best option when handling an inherited IRA depends heavily on your specific circumstances and financial goals. It’s vital that you learn about its rules, options, and potential tax ramifications so that you can make informed decisions regarding future plans for it. Consulting a financial adviser or tax professional could prove wise to find an optimal path.
An inheritance of an IRA can provide significant financial resources; however, its rules can be complex and potentially carry tax implications that require careful attention from both you and professional advisors to maximize its use for you and meet your personal financial goals and needs.
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