An estimated $30 trillion in wealth will change hands over the next 30 to 40 years as baby boomers pass on assets to their heirs. Some of those assets are held in retirement plans, including individual retirement accounts. According to an RBC Wealth Management survey, however, only 20 percent of those who will inherit have a plan for handling the wealth transfer.
Patrick Simasko, an elder law attorney and wealth preservation specialist with Simasko Law in Mount Clemens, Michigan, says inheriting an IRA is something more investors should prepare for. In the past, Social Security and pensions figured heavily in workers’ retirement plans, Simasko says. Now, employers increasingly favor 401(k)s, and uncertainty over Social Security’s future is growing. Those changes mean “inherited IRAs will become a large component of today’s retirement plan,” as savers could use the money for their own retirement.
According to the 2017 TIAA IRA Survey, 19 percent of Americans contribute to an IRA. Through the fourth quarter of 2016, the average IRA balance was $93,700, surpassing the average 401(k) balance, which hit an all-time high during that same period. Although inheriting an IRA can change your retirement picture for the better, you’ll need to manage those savings along with your own while avoiding unnecessary taxes.
[See: 8 Things Not to Hide From Your Investment Professional.]
Non-spouse heirs. Your relationship to the original account owner makes a difference in how you treat an IRA you’ve inherited. Non-spouses can transfer the money into an inherited IRA. These accounts are subject to required minimum distributions based on the heir’s life expectancy. Those distributions must begin no later than Dec. 31 of the year following the account owner’s death. Distributions are taxable at the new owner’s regular income tax rate and are required even if you inherit a Roth IRA, which ordinarily wouldn’t be subject to the RMD rule.
If you want to skip required minimum distributions, you could take a lump sum distribution instead, says Michael Hohf, a financial advisor and certified financial planner at Advance Capital Management in Southfield, Michigan. But there are tax consequences.
“If you decide to take an immediate lump sum distribution, that income is taxed at your marginal tax rate,” Hohf says. The 10 percent early withdrawal penalty would, however, be waived if you’re withdrawing money from an IRA before age 59½.
Greater flexibility for a husband or wife. A spouse who inherits an IRA has even more choices, says Chip Olson, senior vice president at People’s United Wealth Management in Bridgeport, Connecticut. A spouse could transfer the money into an inherited IRA or treat the IRA as his own. In that scenario, RMD rules would still apply, but a spouse could postpone taking distributions until age 70½.
Keeping the IRA in the deceased spouse’s name is another option. Olson says that could make sense if the deceased spouse were younger, “because then RMDs would be calculated from their life expectancy.”
A lump sum is another option, although it will depend largely on your tax bracket, says Paul Rabelais, an estate planning attorney at Rabalais Estate Planning in Baton Rouge, Louisiana. “If a person is in a lower tax bracket and expects to be in a higher tax bracket in later years, it might make sense to take the distribution and pay taxes at the lower rate,” he says.
[See: The Best ETFs Retirees Can Buy.]
Both spouses and non-spouses can open an inherited IRA and distribute the entire account balance by Dec. 31 of the fifth year after the year the account holder died. If the distributions are from a traditional IRA, regular income tax applies, but the 10 percent early withdrawal penalty is waived.
Tax rules for inherited Roth IRAs depend on how long the account was open before the owner passed away, says Barry Kozak, a consultant at Chicago-based October Three Consulting. “As long as the account holder was age 59½ and the Roth IRA had been established for at least five years, all distributions are tax-free,” Kozak says. On the other hand, if the account owner was younger than 59½ or the IRA was less than five years old, the original contributions to the account would be tax-free, but the earnings would be subject to income tax.
The most important thing to understand with inherited IRAs is when the RMD rule applies, says Leann Sullivan, vice president of TFC Financial Management in Boston. “The mistake people often make with inherited IRAs comes from a lack of understanding as to how much needs to be distributed and when to begin distributions,” Sullivan says. “Missing any required IRA distributions carries a stiff penalty — 50 percent of the amount not distributed,” so it’s in your interest to understand which option works best for you.
Tailor those investments. Inheriting an IRA doesn’t mean you’re stuck with the original account owner’s investment choices, says Leslie Thompson, managing principal at Spectrum Management Group in Indianapolis. “With a few exceptions, you can invest IRA assets in the same manner as non-IRA assets,” she says, but you still get the benefit of tax-deferred growth, or tax-free distributions in the case of a Roth IRA.
If you’re not sure how to choose investments, Hohf says looking at the IRA’s overall asset allocation is a good place to start. If the person you inherited the account from was older than you, for instance, the IRA’s investments may not match your risk tolerance or goals.
Additionally, you’ll need to consider your time horizon and the tax status of your other investments. Thompson says that if you don’t need to live off the inherited assets, it’s best to invest for long-term growth. If you’re nearing retirement, however, you may want to allocate more of your inherited IRA investments to conservative, fixed-income assets.
[See: 7 Reasons to Invest in an IRA.]
You should also have an idea of how to invest any required minimum distributions you’re taking from an inherited IRA. Sullivan says the after-tax portion of the distribution can be added to taxable savings for retirement to supplement your tax-advantaged assets. “Although a minimum amount must be distributed from the IRA annually and taxed, that doesn’t mean it has to be spent,” she says.
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What You Should Know About Inherited IRAs originally appeared on usnews.com
