Did You Inherit an IRA? Here’s What You Need To Know!
True Root Financial is a financial advisor and financial planner based in San Francisco, CA. We serve clients across the globe.
Rob, a marketing professional who works for a tech company in Silicon valley, inherited an IRA from his mother in 2020. Initially, he misunderstood the requirements, believing he could spend down the IRA over his lifetime. However, with the new IRS guidance, he learned that he must now spend the IRA down over 10 years starting from 2025. Additionally, the amount he needs to take each year may not be even. The amount is dictated by a formula that takes several factors into account, including life expectancy.
Key Takeaways:
- You are now required to spend down an IRA that you inherit over a period of 10 years. Previously, you were required to do so over your lifetime
- It’s important to note that this rule does not apply to spouses, meaning that if you inherit an IRA from your deceased spouse, you’re not required to spend it down over 10 years
- How much do you need to spend each year? This will depend on a number of factors including life expectancy. Your IRA account advisor should be able to guide you
- Roth IRAs are more advantageous as they allow tax-free withdrawals and do not require distributions until the tenth year
- Consulting with financial advisors is crucial to navigate these regulations effectively.
The Shift In Rules
Previously, you could benefit from ‘stretch IRAs’, which enabled you to prolong withdrawals over decades, thus leveraging compound interest for significant growth. However, the SECURE Act of 2019 stipulated that many heirs must now deplete inherited individual retirement accounts (IRAs) or 401(k)s within ten years. The ambiguity remained as to whether these withdrawals needed to be annual or could be postponed until the end of the decade. The IRS has now clarified that annual withdrawals are mandatory for most heirs, aligning with what they interpret as Congressional intent.
Summary of rule changes:
| Aspect | Old Rules | New Rules |
| Withdrawal Period | Withdrawals could be stretched over the heir’s lifetime. | Withdrawals must be completed within 10 years of the original account holder’s death. |
| Annual Withdrawals | No annual withdrawal requirement; heirs could take distributions at their discretion. | Annual withdrawals are required for most non-spousal heirs. |
| Beneficiary Types Affected | Applied to all beneficiaries, including spouses and non-spousal heirs. | Spouses are largely exempt from the new rules; mainly affects non-spousal heirs (e.g., children, friends). |
| Required Minimum Distributions (RMDs) Start Age | Account holder’s RMDs began at age 70 1⁄2 (now 73 under new legislation). | No change for original account holders; heirs must take annual withdrawals if the account holder was taking RMDs. |
| Flexibility in Withdrawals | High flexibility, allowing heirs to minimize tax impact and maximize account growth. | Reduced flexibility, with mandatory annual withdrawals potentially increasing the tax burden. |
| Penalties for Missed Withdrawals | 50% penalty on missed RMDs. | 25% penalty on missed RMDs, with a waiver for missed withdrawals from 2021 to 2024. |
| Roth IRA Inheritance | No mandatory withdrawals; tax-free distributions. | Withdrawals are still required by the end of the 10th year, but distributions remain tax-free. |
Who Does This New Rule Affect?
This change affects you if you inherited the IRA from someone else besides a spouse such as from a grand-parent, sibling, friend, etc. Notably, spouses who inherit IRAs remain subject to a different set of rules, preserving some of the old flexibility. Furthermore, if the person who gifted you the IRA was under 73 years old and had not begun taking their required minimum distributions (RMDs) at the time of death, you can still wait until the tenth year to withdraw the full amount.
How Does This Affect Your Finances?
For many families, this means adjusting financial plans to account for the new withdrawal schedule. The impact is particularly pronounced for those who had intended to allow the inherited accounts to grow over a longer period, leveraging the power of compounding. The need for annual withdrawals imposes a more immediate tax burden and could alter long-term financial strategies.
What Are The Future Implications?
Due to widespread confusion about the new rules, the IRS has waived penalties for missed withdrawals from 2021 through 2024. This temporary relief acknowledges the uncertainty and lack of guidance that characterized the early years of the SECURE Act’s implementation. Starting in 2025, however, you must start spending from the inherited IRA in the amount, calculated based on your life expectancy. This reprieve gives you some time to adjust your financial strategies.
While this relief period is beneficial, it also underscores the importance of proactive financial planning. If you’re inheriting an IRA, you and your advisor should use this time to familiarize yourselves with the new requirements, calculate potential tax impacts, and develop a strategy for managing the annual withdrawals. This preparation will be crucial in mitigating any negative financial consequences once the mandatory withdrawal period begins.
Tax Considerations
In this world, nothing can be said to be certain, except death and taxes – Benjamin Franklin.
Withdrawals from traditional IRAs are taxable, adding another layer of complexity. You must be cautious about how you manage these distributions to avoid a balloon payment in the final year, which could push them into a higher tax bracket. For instance, if a $100,000 IRA inherited in 2020 grew to $151,000 by 2030 with no distributions taken until the final year, the heir could face a significant tax burden. Conversely, Roth IRAs offer a more favorable scenario, as withdrawals remain tax-free and are not required until the tenth year.
Understanding the tax implications of these withdrawals is critical for effective financial planning. You should consider their current and projected future income levels when deciding how much to withdraw each year. Taking larger distributions in years when income is lower can help manage the overall tax burden, while deferring larger withdrawals to years when income might be lower can also be a strategic move.
How To Plan Ahead?
These evolving rules underscore the need for meticulous financial planning and adaptability. As Congress continues to adjust retirement account regulations, you must stay informed and prepared to navigate the maze of changing laws. Consulting with financial advisors and tax professionals can provide critical guidance to optimize inheritance strategies and minimize tax liabilities.
Effective planning involves not just understanding the rules but also anticipating future changes. The legislative environment around retirement accounts is dynamic, and staying abreast of potential changes can help you make informed decisions. Regular consultations withyour financial advisor will ensure that strategies remain aligned with current laws and best practices.
Have You Considered A Roth Conversion?
The best type of IRA to inherit is a Roth IRA. You don’t have to take the money out until the 10th year, and withdrawals are generally tax-free. Roth IRAs offer more flexibility and fewer tax implications, making them an attractive option for both the original account holder and the heir. If you have the option to convert traditional IRAs to Roth IRAs during your lifetime, it might be worth considering to ease the burden on your heirs.
How Can A Financial Advisor Help You?
If you have multiple IRAs, they may each have different payout rules. For example, you could be taking required payouts from your own IRA, calculating the payouts using one set of life expectancy rules. Then, if you inherit an IRA, you have to calculate the payout for that IRA using different rules.
Managing multiple IRAs with varying rules can be particularly challenging. Each account may have its own set of requirements based on when it was inherited and the type of IRA. You need to carefully track each account and ensure they comply with the specific rules applicable to each. This complexity underscores the value of working with a financial advisor who can provide guidance and help avoid costly mistakes. Book a call below.
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