If the baby boomer generation becomes known for one quality, it might be its generosity. The consulting firm Accenture estimates that baby boomers will pass on around $30 trillion – yes, trillion! – to their heirs over the next few decades. A significant portion of this wealth will be transferred in the form of an inherited IRA.
An inherited IRA can be an incredible financial tool for beneficiaries. Primarily, it can greatly improve your chances for achieving your own retirement goals. But, there are a variety of rules to navigate. If you make a wrong move, your financial gift could become a tax liability. Therefore, carefully consider how to best incorporate an inherited IRA into your retirement plan before you touch the money.
Understand the tax consequences of inherited IRAs
From a tax standpoint, distributions from an inherited IRA are subject to ordinary income tax, just like a traditional IRA. What’s different is that distributions from an inherited IRA are not subject to any sort of tax penalty.
This can offer a lot of flexibility for someone who retires prior to age 59 ½ (where regular IRA withdrawals can be subject to a 10% penalty), or for someone who is working yet needs access to some retirement money.
Find out if the account owner fulfilled the five-year holding period
One unique factor that applies to an inherited Roth IRA is the five-year holding period. This rule says that if the original owner held his or her contributions in the account for more than five years, then a beneficiary of that Roth IRA can take distributions from an inherited Roth IRA without being taxed.
If the owner of the Roth IRA did not hold his or her contributions for at least five years, then a portion of the distributions (the earnings) is subject to ordinary income tax. You can check with the custodian of the Roth IRA to learn if the owner met the five-year holding period.
Learn what rules apply to you
Your relationship to the original IRA owner is very important. It essentially determines what rules apply to you.
Spouses have the unique ability to inherit an IRA or Roth IRA and treat it as their own. A spouse that chooses to treat an inherited IRA as their own is not required to take annual Required Minimum Distributions (RMDs), which can be a significant tax benefit.
Non-spouse beneficiaries, on the other hand, don’t have the luxury of just letting that money sit and grow. They must take RMDs from inherited retirement accounts.
Plan for RMDs
If you inherit an IRA, you’ll likely need to account for RMDs when managing your retirement assets. Remember, RMDs are required by the IRS to ensure that investments in IRAs don’t grow tax-deferred or tax-free (in the case of a Roth) forever.
An IRA beneficiary must begin taking RMDs by December 31 of the year following the original IRA owner’s death. The tax penalty for not fulfilling your RMDs is stiff – 50% of the amount you were required to take out. Watch our short video on RMD Rules to learn more.
Consider a lump-sum distribution as a last resort
If you want to avoid taking RMDs all together, you can always elect a lump-sum distribution. But there are two very important things to consider before making this decision.
One is the tax consequences. If you take an immediate lump-sum distribution, that income will be added to your other forms of income and taxed at your marginal tax rate. You could find yourself bumped into a higher tax bracket.
The other, and perhaps more important, thing to think about is the potential growth that would be lost by not keeping the money invested. As a rule of thumb: If you don’t have an immediate need for the money, don’t take an immediate lump-sum distribution!
Avoid these common mistakes
There are two common mistakes I see people make when inheriting an IRA.
The first – and biggest – mistake is immediately liquidating the account. Often, there is a significant amount of money in these IRAs. It is usually enough to take the beneficiary from just decent financial shape to very good financial shape. So, it can be tempting to treat the money as an unexpected windfall and spend it. That would cost you big time later in retirement.
Think of the famous “Marshmallow Test,” a psychological study in which a group of children were given one marshmallow immediately to eat, but if they waited a little longer they received two marshmallows. So, steer clear of the expensive car or second home now. Instead, keep the money invested. It will give you much more financial freedom once you reach retirement.
The second common mistake is keeping the same investments as the original IRA owner. Assuming you inherit the account from someone older than you, it’s likely the asset allocation chosen by that person isn’t appropriate for you. You may need to change the account’s investments to align with your personal financial situation – your time horizon, the tax status of your other investments and your risk tolerance.
An inherited IRA can come with a lot of strings attached. The most effective way to balance these factors and your financial objectives is to have a financial plan. It will help you prioritize your goals and guide you as to how best to utilize an inherited IRA for your retirement planning needs.
To learn more about what inherited IRA rules may apply to you, download Advance Capital’s Guide to Inherited Retirement Accounts. Click the link or image.
Whether you’re a spouse, family member, friend or trustee, this guide shows you the various options available to you as an IRA beneficiary so you can make the right decision. I also recommend consulting with a financial adviser who can review and provide solutions to your specific situation.
Michael Hohf is a CERTIFIED FINANCIAL PLANNER™ who provides comprehensive wealth management solutions, such as retirement planning and investment advice, to help clients work toward achieving their financial goals. He is also one of Dave Ramsey's designated SmartVestor investing professionals.