How Inherited IRAs Work
In the realm of retirement planning, individual retirement accounts (IRAs) stand out as indispensable tools. However, as important as it is to understand how these accounts operate during an account holder’s lifetime, it’s equally vital to grasp what happens to these funds after the account holder’s death. Enter the world of inherited IRAs.
The Basics of Inherited IRAs
In its simplest terms, an inherited IRA, sometimes called a “beneficiary IRA,” is an account passed on after the original account owner’s death. While the concept might seem straightforward, the rules governing inherited IRAs can be complex. These rules also underwent a significant transformation with the introduction of the SECURE Act in 2019.
Key Changes Under the SECURE Act
Before the SECURE Act, beneficiaries of inherited IRAs, with some exceptions, could “stretch” out the required minimum distributions (RMDs) over their lifetime. This “stretch” provision was particularly beneficial for younger beneficiaries, like children or grandchildren, as it allowed for minimal withdrawals and maximized tax-deferred growth.
The SECURE Act introduced a paradigm shift:
10-year rule: Most beneficiaries (called non-eligible designated beneficiaries) are now required to withdraw all assets from an inherited traditional IRA within 10 years following the original account holder’s death.
Generally, this 10-year rule has no mandated RMDs each year, but the account must be depleted by the end of the 10th year.
However, as this Forbes states, “the IRS proposed changes that would require some beneficiaries to take RMDs and empty the account in 10 years.” The ongoing changes generally would affect non-eligible designated beneficiaries where the original owner of the traditional IRA was subject to RMDs when they died. These heirs would be required to take RMDs based on their life expectancy in the first nine years and then take out the rest of the balance in the 10th year.
The Forbes article continues: “A final rule was expected by early 2023. But … the IRS again waived penalties on missed distributions for [2021, 2022, and] 2023 and indicated that final guidance won’t come until 2024.”[1] This can be a planning opportunity for these beneficiaries to help reduce their account balance before they are required to take larger distributions and potentially increase their taxes.
Exceptions for eligible designated beneficiaries: Not everyone is subject to the 10-year rule. Eligible designated beneficiaries, including surviving spouses, minor children (until they reach the age of majority), beneficiaries within 10 years of the deceased’s age, and those chronically ill or disabled, can still stretch RMDs over their lifetime.
Tax Implications
With these new rules, beneficiaries should understand potential tax consequences. Distributions from traditional IRAs count as ordinary income, and a substantial withdrawal can inadvertently nudge a beneficiary into a higher tax bracket. Strategic planning over the 10-year period is crucial to manage the tax ramifications effectively.
For those inheriting Roth IRAs, the landscape is a bit more accommodating. While the 10-year rule applies, distributions are generally tax-free if the original Roth IRA meets the five-year aging requirement.
Existing Inherited IRAs and the SECURE Act
It’s essential to highlight that the SECURE Act’s provisions don’t affect inherited IRAs where the original account holder passed away before January 1, 2020. Those heirs can proceed under the old rules, taking RMDs based on their life expectancy.
Navigating Inherited IRAs: Steps to Consider
Determine your beneficiary status: Identify if you are an eligible or non-eligible designated beneficiary, as this determines your distribution requirements.
Assess the type of IRA: Whether it’s a traditional IRA or a Roth IRA, understanding the type you’ve inherited helps forecast potential tax obligations.
Consult with professionals: While it’s valuable to educate oneself, the intricate landscape of inherited IRAs often necessitates guidance from tax professionals or fiduciary financial advisors.
Strategize your distributions: Whether stretching it over several years or opting for a lump-sum withdrawal, decide on a distribution strategy that aligns with your financial goals and minimizes tax implications.
Final Thoughts
Navigating the world of inherited IRAs requires a fusion of knowledge and strategy. While the SECURE Act has reshaped the landscape, a well-informed approach can help ensure that the inherited wealth is managed judiciously.
At Parkshore Wealth Management, we recognize the profound impact inherited IRAs can have on one’s financial journey. As a fee-only, fiduciary Registered Investment Advisor (RIA) with a footprint in both California and Utah, our commitment lies in guiding clients to make informed decisions about their inherited IRAs as part of their financial planning process.
Schedule a complimentary, 15-minute chat with a fee-only, fiduciary financial advisor today to discuss your personal situation.
This material was written in collaboration with artificial intelligence (ChatGPT) derived from sources believed to be accurate. This information should not be construed as investment, tax, or legal advice.
Parkshore Wealth Management is a family-owned, independent, fee-only Registered Investment Advisor with offices in Granite Bay and Folsom, CA, and Lehi and Logan, UT. We partner with financially responsible individuals and families who are eager to take positive steps that will allow them to use their money to build the life they desire. The firm is led by Harold Anderson, CFP®, and Daniel Andersen, CFP®, both members of NAPFA, the country’s leading professional association of fee-only financial advisors.
[1] Kristin McKenna, “Beneficiaries of Inherited IRAs Get More RMD Relief—for Now,” 19 July 2023, https://www.forbes.com/sites/kristinmckenna/2023/07/19/beneficiaries-of-inherited-iras-get-more-rmd-relief---for-now/?sh=534a74253266.