I was in the process of writing an article on handling inherited IRAs when Congress passed the SECURE Act and changed everything. But while things have certainly changed, one thing remains the same: you need to perform due diligence on how to handle an inherited IRA if you want to reduce the amount of taxes you pay.
The new SECURE Act rules dictate that inherited IRAs need to be distributed within a 10 year time period. There are a number of other changes implemented with the SECURE Act, but the change to inherited IRAs is one of the biggest. Anyone inheriting an IRA from a person that passed in 2020 has a 10-year time period to withdraw all assets from the account. If all assets aren’t distributed by the end of the 10 years, then the owner faces a penalty of 50%.
Now that we know the rules, what does this mean to a person that inherits an IRA? And are the rules different for traditional IRAs and Roth IRAs?
Inherited Traditional IRA
If you inherit a traditional IRA it is essential to do some planning to limit your tax payment. Keep in mind that you can withdraw any amount you want at any time during the 10-year period, so withdrawals are as flexible as you want them to be. The key is choosing a timeline and strategy that doesn’t break the bank from a tax liability standpoint.
For example, looking at a $500,000 IRA, an individual could choose to:
(a) Let the money grow for the full 10 years and then take a lump sum.
(b) Take a lump sum right away.
(c) Take annual distributions, spreading the inherited funds out over time.
The plan that works best will largely depend on how the distributions will affect the inheritor’s income tax bracket.
If the individual leaves the entire amount to withdraw in the 10th year, the 500k could easily grow to over 1 million. But, if the goal is to reduce the amount of taxes paid, delaying until year 10 isn’t a good option. Doing so would put the owner in the highest possible income tax bracket of 37% (and that doesn’t even include state taxes). The same is true of taking a lump sum right away.
Annual distributions of 60-80k would likely be the best strategy in this scenario, but that again comes back to the beneficiary’s tax bracket. If the beneficiary is already in the 37% tax bracket, then waiting until year 10 to maximize tax deferred compounding may be best. However, most federal employees in the 12-24% tax brackets will benefit from taking annual distributions in order to limit payments to Uncle Sam.
Here is a real-life scenario:
Household taxable income: $150,000.
Tax filing status: married filing jointly.
Federal tax bracket = 22%
Next bracket of 24% starts at $168,401.
The 32% bracket starts at income of $321,451.
This household’s strategy should be to stay out of the 32% tax bracket. If they are able to do that, they keep at least 8% more of the IRA. If they take distributions of $70,000 a year while averaging a 7% return, they will have nearly depleted the IRA in a 10-year time period (while staying out of tax brackets higher than 24%).
If you are a business owner and show significant business loss in any given year, then a larger distribution in that year would be wise. This comes back to the “go to” financial planning answer of “everyone is different and there is no perfect answer that applies to every situation.”
One thing to keep in mind with the info and examples provided here is that federal tax rates can change, and likely will change over time. In other words, you always need to be aware of what income tax rates are and if any changes are anticipated.
Inherited Roth IRA
Roth IRAs grow income tax free and are distributed income tax free. These facts make the strategy with Roth IRAs really simple - delay till year 10. If you choose this strategy, please make sure you know when the 10-year window is up so you don’t wait too long and incur a penalty. Again, if you have a lump sum in an account that will grow income tax free for a decade, take advantage of those 10 years.
Inheriting an Inherited IRA
The same rules apply when inheriting an inherited IRA. The beneficiary of an inherited IRA is allowed the same 10 year time period as the original beneficiary, therefore the same principles apply when deciding how to distribute the IRA.
Inheriting an inherited Roth IRA would be the same as mentioned: take advantage of the 10 years of income tax free growth.
Financial planning often boils down to strategic efficiency that seeks to protect and grow your assets over time. Because taxes can threaten this growth, they are one of the biggest components of financial planning. Knowing the details of inheriting an IRA can help you limit taxes paid and make the most of your inherited assets. If you are a federal employee looking for a fiduciary to help you on your retirement journey, please schedule an introductory call. I look forward to getting to know you.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.