The Inherited IRA
As baby boomers continue to age, we are going to see trillions of dollars be passed to beneficiaries over the next 20 years.
Trillions- with a “T”
That’s a whole lot of dough…
The most common type of account that will be left to a beneficiary is an IRA.
One option you have as the beneficiary of an IRA is to extend its financial life across multiple generations, in the form of an Inherited IRA.
It is a pretty amazing tool that can be used in generational income planning.
Because of that, it’s important that you understand the special rules that apply to “inherited IRAs.”
1) It’s not really “your” IRA
As an initial matter, while you do have certain rights, you are generally not the “owner” of an inherited IRA. The practical result of this fact is that you can’t mix inherited IRA funds with your own IRA funds. Also, you can’t make 60-day rollovers to and from the inherited IRA.
You also need to calculate the taxable portion of any payment from the inherited IRA separately from your own IRAs, and you need to determine the amount of any required minimum distributions (RMDs) from the inherited IRA separately from your own IRAs.
2)Required minimum distributions
As beneficiary of an inherited IRA–traditional or Roth–you must begin taking RMDs after the owner’s death.* In general, you must take payments from the IRA annually, over your life expectancy, starting no later than December 31 of the year following the year the IRA owner died.
In some cases you may be able to satisfy the RMD rules by withdrawing the entire balance of the inherited IRA (in one or more payments) by the fifth anniversary of the owner’s death.
In almost every situation, though, it makes sense to use the life expectancy method instead–to stretch payments out as long as possible and take maximum advantage of the IRA’s tax-deferral benefit.
You can always elect to receive more than the required amount in any given year, but if you receive less than the required amount you’ll be subject to a federal penalty tax equal to 50% of the difference between the required distribution and the amount actually distributed.
3) More stretching…
What happens if you elect to take distributions over your life expectancy but you die with funds still in the inherited IRA?
This is where your IRA custodial/trustee agreement becomes crucial. If, as is sometimes the case, your IRA language doesn’t address what happens when you die, then the IRA balance is typically paid to your estate–ending the IRA tax deferral.
Many IRA providers, though, allow you to name a successor beneficiary. In this case, when you die, your successor beneficiary “steps into your shoes” and can continue to take RMDs over your remaining distribution schedule. Which is how you can create a multi-generational tool.
MAKE SURE YOU NAME A SUCCESSOR BENEFICIARY!
4) Federal income taxes
Distributions from inherited IRAs are subject to federal income taxes, except for any Roth or nondeductible contributions the owner made. (check your tax bracket here )
But distributions are never subject to the 10% early distribution penalty, even if you haven’t yet reached age 59½. This is huge—even young kids can take distributions with no penalties!
When you take a distribution from an inherited Roth IRA, the owner’s nontaxable Roth contributions are deemed to come out first, followed by any earnings.
Earnings are also tax-free if made after a five-calendar-year holding period, starting with the year the IRA owner first contributed to any Roth IRA. For example, if the IRA owner first contributed to a Roth IRA in 2014 and died in 2016, any earnings distributed from the IRA after 2018 will be tax-free.
5) Creditor protection
Traditional and Roth IRAs are protected under federal law if you declare bankruptcy. The IRA bankruptcy exemption was originally an inflation-adjusted $1 million, which has since grown to $1,283,025.
Unfortunately, the U.S. Supreme Court has ruled that inherited IRAs are not covered by this exemption. (If you inherit an IRA from your spouse and treat that IRA as your own, it’s possible that the IRA won’t be considered an inherited IRA for bankruptcy purposes, but this was not specifically addressed by the Court.)
This means that your inherited IRA won’t receive any protection under federal law if you declare bankruptcy. However, the laws of your particular state may still protect those assets, in full or in part, and may provide protection from creditors outside of bankruptcy as well.
Wrap up
There you have it—5 short things you should know about inherited IRA’s. If you are the beneficiary of someone else’s IRA and they pass away, do not rush to do anything. Take your time, understand your options and set yourself up for success.
As always, you can consult with me to discuss your current situation.
Look for future posts on the best ways to protect your family financially and check out my recent post on retirement income planning 2.0.
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Thanks for stopping by and I hope you achieve financial success!
