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Inherited IRA Beneficiary and Estate Planning Considerations Thumbnail

Inherited IRA Beneficiary and Estate Planning Considerations

In this video, Tim discusses Individual Retirement Accounts (IRAs) as well as inherited IRAs, beneficiaries of different account types, and some estate planning items to consider.

We're going to cover the nuances when inheriting the assets of an IRA. Options when inheriting an IRA will depend on the relationship of the beneficiary to the IRA owner, whether the IRA was funded with pretax or after-tax money, and whether the account owner had crossed the threshold where they were required to take minimum distributions (RMDs). 

IRA Beneficiaries

Generally, when a beneficiary inherits the assets in a qualified retirement plan (like an IRA), or a trust, or they receive the proceeds of a life insurance policy, this happens outside of a will. 

Therefore, it’s very important to have your beneficiaries set up properly and that you review this frequently since life happens and things change. People often forget, or didn’t even know, that beneficiary designations for retirement accounts take precedence over a will or estate documents. This means if you get a divorce and then update your will or estate documents but forget to update your beneficiaries, there will be some big problems if you pass away. So never forget to update your beneficiaries. 

You can designate one or more relatives, or non-relatives, or a charity, or a trust as a beneficiary. If no beneficiary is named, the account will be part of the owner’s estate, and therefore, subject to probate. If you can, you’ll want to avoid probate because it is a time-consuming and generally expensive process. 

Important side note: Other accounts like bank and taxable investment accounts would generally pass to beneficiaries through a will, but then they must go through probate. However, you can typically avoid probate if you have designated a POD or TOD. A POD is a beneficiary named as Payable on Death for bank and/or credit union accounts, and a TOD is for Transfer on Death for accounts holding stocks, bonds, and/or any taxable brokerage accounts.

Inheriting an IRA

Generally, when an IRA owner dies, the IRA assets will be transferred to a new inherited IRA in the name of the original IRA owner for the benefit of the beneficiary. The beneficiary cannot make contributions or roll money out of an inherited IRA.

The tax treatment of the inherited IRA will depend on if the original IRA was funded with pretax money, as it would be in a traditional IRA, or after-tax money, as in a Roth IRA.

If the original IRA was funded with pretax money, the heir will have to pay ordinary, 7-bracket income taxes in the year money is withdrawn from the inherited IRA. So if the heir is still working, this money will be added to their income and taxed accordingly. 

If the original IRA was funded with after-tax money and is in a Roth IRA, the heir will not have to pay income taxes on withdrawals. This is obviously, a huge benefit of Roth IRAs

Under the SECURE Act, effective in 2020, inherited IRA assets have to be paid out to most beneficiaries within 10 years of inheritance. This is unfortunate and disappointing because it’s basically another shadow tax or kind of a hidden tax on the middle and upper middle class. 

Before the SECURE Act, required distributions could be stretched out over the beneficiary’s remaining life expectancy, allowing distributions to be kept relatively low and therefore, taxes to be kept lower and more manageable. However, the SECURE Act eliminated this Stretch IRA.

This means, if your children are the beneficiaries, as is common, this leads to a high probability that they will have to take distributions during what are likely to be peak earning years, and these distributions will now be stacked on top of their peak earning income, so they will likely have to pay very high tax rates on the legacy assets.

As for inherited Roth IRAs, they also must be withdrawn within 10 years, but since they are tax-free, they won't increase the beneficiary's tax liabilities.

Roth IRA Conversions

This alone makes Roth IRA conversions a key tool for legacy planning, not to mention using Roth conversions to limit your own lifetime tax liabilities. As I’ve mentioned previously, I believe we are in the Golden Age of Roth IRA conversions since our tax rates are as low as they’ve been in 100 years, and it’s unlikely they will go lower. 

We want to pay taxes when they are the cheapest or lowest, right?!  

Bottom Line:

As you can see, there are a few very important considerations to think about when considering the legacy of your IRA or any retirement plan assets.

You need to pay close attention to your designated beneficiaries to make sure your money is going where you want it to go, and pay close attention to how and when your heirs might receive assets because it can have large implications on your estate tax liabilities and their lifetime tax liabilities.

And of course, you will want to discuss your specific situation with an estate planning attorney.

A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation. 

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