Inherited IRAs - Part 2

We recently began a look into the complexities involved in passing on individual retirement accounts with a look at the basic rules. The rules of how inherited IRAs are handled depend on when the owner died and their relationship to whomever is inheriting the account.

• That first post can be found here: Inherited IRAs - Part 1
• Next month, we will consider strategies for naming the beneficiaries who will inherit your IRAs.

Planning Wrinkles — This month, we look at planning options for handling an inherited IRA. There are requirements for taking distributions (which will be taxable as income unless it’s a Roth IRA). This creates some complexities for managing the size and timing of the distributions to maximize their benefit after taxes.

Before moving ahead with one of the many distribution choices, GEM recommends consulting with a finance or tax professional to fully understand your options.

The Big Plunge — The simplest way to handle an inherited IRA is to just liquidate the account and immediately distribute the funds. However, the amount is subject to federal and state income taxes. Meaning if the beneficiary is a higher earner, 40% or more of the account could immediately be consumed by taxes.

• For this reason, most of our clients choose to manage the account and include it as part of their overall financial plan. After all, most people are working to limit their tax exposures and grow their wealth within tax-deferred accounts.

Spouses — Generally, individuals inheriting their spouse’s IRA as a beneficiary have a simpler course of action. They may add the inherited IRA assets to their own account, then distributions are determined based on their own age and life expectancy. If the surviving spouse doesn’t need the income, this strategy can preserve more of the account by stretching the distributions over more time.

• TIP #1 — In some cases (particularly if the surviving spouse is younger or older than the deceased spouse), it may be more advantageous for the spouse to assume the account as an Inherited IRA. If the funds are needed, the penalty for taking early distributions would not apply. If the funds are not needed, the required minimum distributions could be deferred until the deceased spouse would have turned 73.
• TIP #2 — It could be strategic to disclaim all or a portion of the IRA. The assets would then pass on to other primary or contingent beneficiaries (children or grandchildren). This could make sense for those looking to preserve the family’s wealth by minimizing their exposure to estate taxes, or if the alternative beneficiaries have a significantly lower marginal tax rate.

Non-Spouse Stretch — If the IRA owner died before 2020, non-spouse beneficiaries  had some attractive options. The beneficiaries could choose to let the funds grow but deplete the account within five years, or to immediately begin taking an annual minimum distribution based on their life expectancy.

• Known as a Stretch IRA, this option allows for prolonged tax-free growth of the assets. The income distributions, although taxable, give the beneficiaries additional planning flexibility. This strategy was disallowed for IRAs inherited after 2020 by the SECURE Act.

Planning Considerations — Stretch IRAs provide options for planning purposes. The beneficiary is required to take a minimum distribution each year. This distribution is taxable, but could be offset with increased contributions to deductible plans like HSAs, 401(k)s, or IRAs is another.

• TIP — Beneficiaries are not prevented from taking more than the required minimum. For example, one could accelerate distributions to bridge the time between retirement and filing for social security benefits, or during another period where taxable income is reduced.  

New Rules — The SECURE Act put into place new rules for anyone inheriting an IRA.  Generally, non-spouse beneficiaries are required to liquidate the account within 10 years and may be required to take annual distributions if the decedent was taking them when they died.

Planning Considerations — With a ten-year window, it may be tempting to distribute all of the funds immediately, or to wait ten years while the portfolio grows tax-tree and distribute it then. However, this may not be optimal (see The Big Plunge above). Planning considerations are mostly about bracket management — getting the funds out of the Inherited IRA at the lowest possible tax rate.

• TIP #1 — Bunching deductions or employing a donor advised fund are some tax planning strategies that might help.
• TIP #2 — Depending on the size of the IRA relative to the beneficiary’s financial position, disclaiming all or a portion to contingent beneficiaries could be an option. Younger heirs may be in lower tax brackets enabling them to retain more of the balance. This can be tricky because heirs can disclaim assets but not direct them. The procedures for named beneficiaries must be observed when one steps back.

Roth IRAs — Generally, distributions from inherited Roth IRAs are tax-free as long as the original account has been open for at least 5 years. They are, however, still subject to the ten-year liquidation rule. The untaxed distributions offer the beneficiary more planning options, such as Roth conversions of their other retirement assets in low tax years.

Bottom Line — There’s a lot to consider when a loved one dies. We at GEM feel that generally, people would like to see their accumulated assets provide as much benefit as possible to those they honor as their beneficiaries. Their assets were gathered over their lifetime with planning and consideration, giving ample consideration to their assets after they’re gone seems appropriate.