Inherited IRA Rules Are Complicated

Inheriting an individual retirement account (IRA) can seem like a welcome surprise. However, an inherited IRA can be quite complex to handle, as estate planning, financial planning, and tax planning are all involved. One wrong step can have expensive consequences.

An Inherited IRA Story*

In February, Dr. Gary Robinson passed away at age 82. He'd not been in excellent health for the last few years but was grateful to still be living independently at home following the death of his wife, Elaine, in 2019. 

As retired dentists, Gary and Elaine left an estate worth nearly eight million dollars to their only son, Dr. Jason Robinson. While the inheritance initially opened up thoughts of early retirement from his intense career as a surgeon, Jason quickly realized that nearly $2,000,000 of the portfolio was in IRA accounts, which are subject to income tax when withdrawn.

Despite his aversion to paying even more taxes each year, his financial planner advised that new IRS rules required him to make withdrawals annually and fully deplete the account within a decade! Even though Jason was only 50 and unable to withdraw from his own retirement accounts, he was forced to withdraw and pay tax each year on his parent's IRAs at his top tax bracket.

What Is an Inherited IRA?

An inherited IRA is a retirement account you receive when someone passes away and leaves their IRA to you as a beneficiary. The key things to understand about inheriting an IRA are:

• You can't contribute new money to an inherited IRA. It's only for the funds you inherited.
• There are special rules about when and how you must withdraw money from the account, which differ depending on your relationship to the original owner and other factors.
• The tax treatment of the inherited IRA generally remains the same as the original account. So, if you inherit a traditional IRA, withdrawals will typically be taxed as income. For an inherited Roth IRA, withdrawals are usually tax-free.
• In many cases, non-spouse beneficiaries must empty the inherited IRA within ten years of the original owner's death. This is known as the "10-year rule."
• Spouses who inherit IRAs have more flexibility in how they can treat the account, including the option to treat it as their own IRA.

How Does an Inherited IRA Affect a Highly Taxed Household?

Physicians, dentists, executives, and other highly taxed households who inherit IRA accounts from their parents quickly learn of the complicated IRS rules governing withdrawals. The Secure Act of 2019 has introduced and changed rules that confound even the most astute tax experts.

If you're feeling frustrated and confused over an inherited IRA account, the following explanations may help.

Two crucial concepts must be understood first:

• Required Beginning Date
• Designated Beneficiary

Required Beginning Date vs Required Minimum Distribution

IRA accounts in retirement are generally comprised of savings that have never been taxed.

Regardless of the wealth or income needs of the account owner, the IRS wants to collect some income tax on the balance. So, around age 73, the IRA owner is required to begin making a minimum withdrawal — known as the required minimum distribution (RMD) — which is a percentage of their account value.

The specific year withdrawals must begin depends on the year of birth, which is known as the required beginning date (RBD). The RBD is the date by which individuals must begin taking RMDs from their retirement accounts, such as IRAs and 401(k)s. The RBD is generally April 1st of the year following the calendar year in which the individual reaches a specific age or retires, whichever is later.

For example, the owner of a $1,000,000 IRA who is 70 years old does not have to make any taxable withdrawal because they have not yet reached their Required Beginning Date of age 73. However, once they turn 73, the required minimum distribution amount for the first year will be approximately $38,000 before tax is paid.

While many beneficiaries are familiar with the concept of a required minimum distribution, the phrase "required beginning date" is used in the Secure Act to reference the withdrawal start date, so it's essential to know the difference.

Eligible Designated Beneficiary vs Non-Eligible Designated Beneficiary

An IRA owner can name nearly anyone as a beneficiary of their account — a spouse, child, sibling, trust, or even a charity.

A designated beneficiary is the term used to identify a real person named as a beneficiary (as opposed to a charity or estate, which are called non-designated beneficiaries).

With the Secure Act, the IRS distinguishes between designated beneficiaries who are eligible to "stretch" the withdrawals over a period of time versus those who are not eligible for this flexibility and must deplete the account over a fixed period of time.

In general, spouses, minor children, and disabled or chronically ill beneficiaries are eligible designated beneficiaries (EDB). They are not required to exhaust the account, following the 10-year rule, but instead are given the flexibility to stretch (or spread) the withdrawals over their lifetimes. This results in greater control over managing the timing and amount of tax liability (although the IRS is always happy for them to withdraw and pay taxes more rapidly!).

It’s important to note that minor children are allowed to take RMDs based on their own life expectancy until they reach the age of majority. Once they reach the age of majority, the 10-year rule applies.

Non-eligible designated beneficiaries are the classification given to most adult children or non-spouse beneficiaries. Prior to the Secure Act, these individuals had the same "stretch" flexibility as spouses, but under the new rules, the IRS requires them to deplete the IRA entirely within 10 years. If the deceased owner had already reached their RBD, the beneficiary must make annual withdrawals leading up to the 10-year deadline.

The chart below may help illustrate these inherited IRA rules:

Final Thoughts on Inherited IRAs

The inheritance of an IRA from a loved one is meant to be a gift. But, as you can tell, the rules are complicated.

As you navigate the process, you'll want to avoid making mistakes that are all too easy to make. While the explanation above is designed to help simplify and clarify the most common situations, and many general questions can be answered online, you may find it beneficial if you've inherited an IRA to speak with your financial advisor and accountant.

If you need an advisor, please let us know. We help our clients coordinate the best strategy for their specific situation in partnership with their tax professionals.

*This hypothetical example is for illustrative purposes only. This is not a prediction or guarantee of actual results. This example is not intended to represent the value or performance of any specific product.

Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.

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