As we discussed earlier this year, 2018 marks the 40th anniversary of the IRA and the 20th anniversary of the Roth IRA. For decades, Americans have been using these investment accounts to take control of their retirement planning and provide their families with favorable wealth building vehicles. The Roth in particular has become extremely popular thanks to its tax-free accumulation. And, as more and more seniors are working in retirement, the ability to keep making contributions for as long as you’re earning income is attractive as well.
Both the traditional and the Roth IRA have been around long enough now that many of our clients at Keen Wealth are coming to us with questions about how to bequeath these assets or provide an inheritance to their families. Inheriting assets can have a big impact on year-end tax prep, so we thought it would be a good idea to devote today’s episode to this topic. If you have inherited an IRA, or believe you may soon, you still have a few weeks to think about the following key points.
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IRA inheritance rules vary depending on who the beneficiary is, and the age at which the account holder passed away. Let’s walk through a couple scenarios:
1. You’re inheriting a traditional IRA from a spouse who passed away before age 70 ½.
Option 1: Open an inherited IRA. If you go this route, the IRS requires that you start taking the required minimum distributions (RMDs) based on your life expectancy by 12/31 of the year after the original account holder’s death.
Option 2: Open a Spousal IRA. Most of the folks we help choose to transfer the inherited assets into a traditional spousal IRA. The benefit is that the IRS treats the inherited money as if it was yours all along, so, you don’t have to take any RMDs until you reach age 70 ½.
Option 3: Take a lump sum. If you take the lump sum within five years of the inheritance, you won’t have to pay any penalties, but you will have to pay taxes on your inherited income.
Option 4: Do Nothing. By doing nothing, you’re choosing to let the “five-year rule” go into effect, which states that the entire account balance has to be distributed by 12/31 of the fifth year after the original account holder died.
The tax ramifications of the five-year rule can be enormous.
Say, for a simple example, you inherit a $1 million IRA. If you were to take even distributions, over the course of 5 years, you would be taxed on each of those $200,000 distributions per year for five years. But if you forgot to take any distributions and realized you had to have the full $1 million distributed in the 5th year, you would be taxed on the entire amount all at once. Ouch!
2. Your spouse passed away after age 70 ½.
This is the most common scenario we see, and the options here are a little more clean-cut:
- You can transfer the inheritance into a spousal IRA.
- You can open an inherited IRA and start taking RMDs based on your life expectancy.
- You can take a lump sum.
3. You inherit an IRA from someone who is not your spouse.
Same options, minus the spousal IRA of course.
In many of these cases, children and grandchildren are the inheritors. If the deceased had other assets outside of retirement accounts, one common strategy is to pass those assets down to children, and to list younger grandchildren as the retirement account beneficiaries to maximize the tax advantages.
If your estate plan involves anyone 18 or younger, you also might consider establishing a trust with some rules that will prevent a young adult from making a rash decision with your legacy.
4. Inheriting a Roth IRA.
You can transfer the Roth to yourself and treat it like your own. This is a great option, because you are able to take minimum distributions (which are tax-free) based on your life expectancy, which will allow the majority of the assets to continue growing tax-free over your lifetime. You also have the options of opening an inherited or spousal Roth, depending on your relationship to the deceased. Keep in mind the inherited Roth will still be subject to the five-year rule though which could force you to lose, potentially, decades of tax-free growth.
I know that all these options and numbers can seem overwhelming. Now imagine trying to sort through all of this while you’re also grieving over a spouse or parent.
That’s one big advantage of working with a fiduciary advisor at Keen Wealth. We can assist you in making sense of the IRS rules and connect you with an estate attorney so that when the time comes, your beneficiaries just need to call us and we’ll handle the rest. No custodians to deal with on their own, no risk of snap decisions before that one-year window closes, just professional advice and service from the team you’ve worked with and trusted for decades.
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Got a question or comment? Email it to me and we’ll get back to you or call our office at (913) 624-1841.
Bill Keen is a CHARTERED RETIREMENT PLANNING COUNSELOR℠ and independent financial advisor with more than 25 years of industry experience. As the founder and CEO of Keen Wealth Advisors, a registered investment advisory firm, he specializes in providing personalized retirement planning designed to help people thrive before and during their retirement years. With a passion for educating others, Bill regularly blogs about retirement planning, hosts the podcast Keen on Retirement, and has contributed to U.S. News and World Report, Reuters, Wall Street Journal’s Market Watch, Yahoo Finance, and other publications. Based in Overland Park, Kansas, Bill and his team work with clients throughout the greater Kansas City area and across the nation. To learn more, connect with him on LinkedIn or visit www.keenwealthadvisors.com.
Keen Wealth Advisors is a Registered Investment Adviser. Nothing within this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Keen Wealth Advisors manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed here. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.