Intergenerational wealth transfers create both opportunities and risks, especially for those inheriting a large sum.
And with the boomer heirs now standing on the precipice of the largest wealth transfer in history, understanding the finer points of inherited wealth is more important than ever.
Inheriting an IRA, for example, has spurred a number of questions from our clients: What options do I have for taking distributions? What are the tax implications? How do I determine the right strategy based on my long term goals? To make evaluating the options simpler, we’ve put together a few guidelines for both spouse and non-spouse beneficiaries to consider when incorporating an IRA into their retirement plans.
Spouse inheritors – Traditional IRA
When one inherits an IRA, the first priority should be to understand the potential tax implications and to avoid any unnecessary penalties. While spouses have the option to roll their inherited IRA into an existing IRA, all inheritors must eventually pay income taxes on traditional IRA distributions. One option open to spouse and non-spouse inheritors is a lump sum distribution. A lump sum distribution involves a payout taken immediately after inheriting an IRA, which will not incur a 10% early withdrawal penalty. The distribution will, however, incur income taxes, and the beneficiary may move to a higher tax bracket as a result of the distribution. Depending on the beneficiary’s age, financial situation and immediate needs, a lump sum distribution may be a preferred option as you will be able to access the funds right away. For spouses over the age of 59½, rolling over an inherited IRA might make more sense, as they will gain control over the distributions, so long as they are above the required minimum distribution (RMD), and the associated taxes.
For beneficiaries who prefer to forego an immediate payout in favor of investing their inherited IRA, they should first identify their goals, and then incorporate their new portfolio into their overall financial plan. Choosing conservative investments, like corporate bonds, may be appropriate for someone who needs their money in the short term. If RMDs are small, and the money will not be needed for a while, a diversified portfolio that includes a mix of equities, alternatives and fixed income may make more sense.
Non-spouse inheritors – Traditional IRA
Non-spouse beneficiaries do not have the option of rolling their inherited IRA into an existing IRA, and must begin withdrawing assets immediately. These distributions will be considered part of the beneficiary’s annual income, and could bump them into a higher tax bracket. Conversely, those who do not realize that they need to take distributions immediately may end up paying a 50% tax penalty on the amount taken below the RMD.
Distributions
Spouse and non-spouse beneficiaries of inherited IRAs may can choose to take distributions as an RMD over the course of their lifetime (life expectancy method), over a five year period, or as a lump sum. The life expectancy option means a RMD will be set each year based upon the beneficiary’s age, and the RMD must be made each year to avoid paying a penalty of 50% on the amount taken below the RMD. The five year option allows the beneficiary more flexibility in that all funds are available for withdrawal throughout the five years, there are no RMDs nor is there an early withdrawal penalty. After five years, any remaining funds in the account will need to be distributed. A lump sum provides access to the assets immediately and sidesteps the 10% penalty for early withdrawals. For most situations, the life expectancy option will be the most beneficial distribution method as the funds that remain in the IRA are afforded a lifetime of tax free growth, prior to distribution.
Roth IRA difference
When inheriting a Roth IRA, the beneficiary will not pay income tax on their distributions nor will distributions be counted as taxable income when determining the beneficiary’s tax bracket. However, if the life expectancy method is the distribution elected, distributions below the RMD will still be subject to the 50% penalty.
People typically make two mistakes when inheriting IRAs: They either forget to take the RMDs, or, with traditional IRAs, they will take a lump sum distribution in a high-income year. The first mistake brings a 50% penalty tax on the amount below the RMD not withdrawn. The second mistake may cause the entire amount to be taxed at a higher rate than necessary. Of course, there are many other aspects to integrating an inherited IRA into your financial plans which we did not address here, as each individual’s specific circumstances and goals will have a unique impact on their immediate and long terms strategies.
For individuals inheriting an IRA, understanding your options as well as the requirements and potential liabilities of those options is essential to making an informed election, and to maximizing your potential benefits. A trusted financial advisor with extensive tax planning and estate planning experience can be a tremendous asset during this process.
