Weekend Read: Things To Consider With Inherited IRAs
Inheriting an IRA comes with various rules and regulations about how the account is taxed and how long you have to distribute it. Depending on when you inherited the account and your income needs, your strategy for taking distributions can vary. Today I’ll discuss both scenarios to help you understand what to consider.
There are a few different types of people who can inherit an IRA. When a spouse passes, their IRA can transfer seamlessly to the surviving spouse if they are named as the primary beneficiary, causing minimal changes. However, when the surviving spouse passes, and the IRA goes to children or other heirs, it becomes an inherited IRA with different rules to consider. We are only going to focus on IRAs inherited by non-spouse beneficiaries, who are adults, and not disabled.
IRAs Inherited Before 2020
Before 2020, if you inherited an IRA from a non-spouse, you could take required minimum distributions (RMDs) for life. An RMD is a yearly distribution the government forces you to take from the IRA, based on your age and the account's value. This distribution is taxed as income. For example, if you’re in a 20% tax bracket and distribute $50,000 from the IRA, you’ll owe $10,000 in taxes1.
The benefit of IRAs inherited prior to 2020 is that don’t have to be fully distributed by a specific date. Depending on the age of the inheritor the RMD is calculated and is stretched out over their life. Of course, they can take out as much as they like as long as they take the minimum which is the RMD1.
IRAs Inherited After 2020
In 2020, Congress passed the Secure Act, changing the rules for inherited IRAs. Now, the entire account must be distributed by December 31st of the 10th anniversary of the original owner's death. This means, you can leave the account untouched for ten years, allowing it to potentially grow tax deferred. However, by the end of the tenth year, you must distribute everything, and income tax will be due on that amount1. This does not mean you must spend it, just that it must be removed from the IRA and taxes paid on the distribution. Many people will remove it and reinvest it in a taxable brokerage account.
This rule presents opportunities and challenges. If you leave a large inherited IRA untouched for ten years, it could grow significantly, potentially leading to a large tax bill if distributed all at once. An alternative strategy is to take distributions in the final few years, such as years 8, 9, and 10, to distribute the tax impact and hopefully reduce it.
Ideally, the distributions from the IRA should be part of a comprehensive strategy that considers, cash flow needs, future income expectations, and any tax planning strategies.
RMDs Rules in the Future
It’s important to note, that the Secure Act of 2020 included some confusing language about whether required minimum distributions (RMDs) are needed during the ten-year period. Currently, it is understood that no distributions are required until the end of the tenth year. However, there is ongoing discussion and the possibility that Congress may clarify the rule and potentially add an RMD requirement in the future. For now, we are operating under the expectation that no RMDs are needed until the end of the ten-year period2.
Final Thoughts
Managing distributions and their tax impact requires careful planning. Taxable income can affect other tax strategies, like Roth conversions, Medicare premiums, and Social Security taxes. As we get further from the law change in 2020, more people will approach the time when they must decide on these distributions. For those who are considering estate planning, considering how inherited assets will be taxed is important as there are strategies that might improve the tax implications.
If you have any questions or need further assistance, I’m here to help. Feel free to reach out by phone or email.
Have a fantastic 4th of July weekend!
1 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
2 https://www.irs.gov/publications/p590b#en_US_2023_publink100090130
Individuals are encouraged to consult their tax and legal advisors (a) before establishing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account. Tax laws are complex and subject to change. Steward Partners does not provide tax or legal advice.
Information contained herein has been obtained from sources considered to be reliable, but we do not guarantee their accuracy or completeness.
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