Losing a loved one is never easy, and neither is handling the finances and/or inheritances that follow. Unfortunately, I have had quite a few inheritance conversations with clients lately. One question I hear often is “What do I do now?”, especially when they inherit a traditional IRA. One recent conversation that came up centered around how to distribute her Beneficiary IRA to minimize her taxes. While it is a blessing to receive a generous IRA, there is now a serious tax issue to handle. It’s an issue that accountants often avoid, but one that must certainly be addressed.
Key Takeaways
- An inherited IRA must be closed within 10 years and requires an RMD if the deceased parent was already required to take an annual RMD.
- Working with a financial advisor to evaluate future taxable income and choosing the right tax planning strategy for emptying an IRA and taking RMDs can potentially save you thousands of dollars in taxes.
Rules and Regs
In the last few years, the IRS finalized some regulations around people who inherit an IRA. Depending on when the original owner passed away, the rules around the inherited IRA change for the beneficiary. There are many new rules around when the owner died, what the relationship is with the beneficiary, how the account was handled before death, what timeline exists after death, the number of beneficiaries, and on and on.
One of the most common scenarios is to receive an IRA from a parent. For those who do, Congress created a 10-year rule requiring the new account to be emptied. Since generally all distributions from an IRA are taxable, it is no surprise why congress created this rule. This rule forces account holders in this scenario to distribute the funds within 10 years, and in doing so, creates more taxes for the government to collect.
To complicate it further, if the deceased parent was past their early 70s when they passed away, they were likely taking Required Minimum Distributions (RMDs) from their account. Congress finalized the rule that your Inherited IRA will also require an annual RMD if the deceased parent was already required to take an annual RMD.
So, it is entirely possible that you may be required to distribute money from your inherited IRA (which gets taxed) each year, and you must close the account by the 10th year following the year of death. For someone blessed enough to receive a significant amount, say $500,000, it can certainly create a future tax liability that must be solved, especially for those who are already in 6-figure households.
There Are Options
One of the reasons why a tax planning professional can help with this problem is that the right thing to do may be very dependent on your current financial situation. If someone ignored this account and only did the minimum distribution each year, what would happen? They would likely get a call in November from someone at Vanguard, JPMorgan, etc., that they must withdraw their RMD for the year, let’s say 3-4% of the account for reference. This would happen for nine years, until eventually they got a call that they must distribute the remaining amount. If there are still hundreds of thousands of dollars in that account by the last year, that could easily spike your tax rate to 30-40% (depending on your situation, of course).
Technically, this strategy is an option, but it generally doesn’t work on paper. Ignoring everything else, it is true that as income increases, so does your tax rate. The federal income tax system is progressive. Meaning the more you distribute from your IRA in a single year, the higher the tax rate could be. Distributing $500,000 from an IRA in one year will have a significantly higher tax rate than distributing $5,000.
The second strategy worth considering is to distribute the account proportionately based on the number of years left before the account must be closed. In other words, the first-year distribution would be 1/10th of the account. The second-year distribution would be 1/9th, the third year would be 1/8th, and so on. This strategy naturally empties the account by the 10th year but also accounts for any investment growth along the way. In theory, this would reduce or eliminate any giant distribution in one year, and instead theoretically spread the tax burden across 10 years. The federal income tax brackets are not evenly spaced, so without considering any other information, it could be possible to save thousands using this strategy compared to the first.
Given the progressive and unevenly spaced Federal tax brackets, the third strategy could be the most tax-aware of the three so far. Once you’ve identified whether you have RMDs, you can roughly calculate your current tax bracket going forward. Then, start distributing the maximum amount each year that keeps you in the same federal tax bracket. For example, there is a large jump from the 12% to 22% tax brackets when someone has over $50,400 in taxable income (or $100,800 if married). In general, it would make more sense over the 20-year span to use as much of the 12% tax rate as possible, while minimizing the 22% rate. This severely oversimplifies the tax system, but the point is valid. Understanding the range of Federal Tax Brackets can help you time distributions throughout the years and reduce the overall tax burden.
Tailor It To You
The final strategy is less a strategy and more a principle. Take the rules around you IRA and apply them to your specific financial plan, and map out your income over the next decade. For example, someone who retires in 5 years could dramatically reduce their income after the fact. Waiting until retirement for IRA distributions could mean the overall taxable income is much lower, and subsequently, the IRA distributions are taxed less. Alternatively, during years with very high incomes (selling a business, property, etc.), it would make sense to stop/minimize distributions for that year. Generally, looking towards the future taxable income over the next few years, given the broader goals and objectives you have, could create “pockets of years” where it makes sense to aggressively distribute the account.
Overall, this is one of the more interesting financial problems because there technically could be a correct strategy. Choosing the right tax planning strategy can potentially save you thousands of dollars in taxes. However, it must always be considered with everything else going on. Changing tax rates, new laws, personal finance changes, health changes, etc., could alter the best strategies. The goal is to start down the path that generally will save you the most. Then you will know you are at least doing the right thing for what you can control.
TC Falkner 