Retirement

3 Mistakes Beneficiaries Must Avoid When Inheriting An IRA

The Secure Act has eliminated the stretch IRA for most people who are inheriting an IRA or 401(k). Now, beneficiaries who inherit an IRA will need to follow the 10-year rule, which can significantly increase the income taxes due on your inheritance, not to mention the new onerous rule of when and how much you must take each year in Required Minimum Distributions.

The New Inherited IRA Required Minimum Distribution Rules

The good news is that stretch IRAs are still available for spousal beneficiaries. However, for most non-spouse beneficiaries (think children, friends), the stretch IRA option has been replaced with a new 10-year payout rule. This rule requires that IRA beneficiaries empty out an inherited IRA balance by the end of the tenth year after death. The new rules apply to IRA beneficiaries who received an inheritance in 2020 or later.

Don’t freak out if you already had an inherited IRA before 2020; you can still follow the old stretch IRA rules. Following the old rules will allow you to make Required Minimum Distributions from your inherited IRA over your lifetime. Spouses and other “eligible designated beneficiaries” are also exempt from the new rules and can still potentially benefit from the stretch IRA. Spouses inheriting an IRA can also often transfer the inherited IRA into an IRA in their name alone.

What Kind Of IRA Beneficiary Are You?

The tax rules regarding your inherited IRA will vary depending on what type of beneficiary you are. Most commonly, were you married to the deceased or not?

It is imperative that you recognize into which category of beneficiary you fall into and what payout rule you must follow. For those receiving substantial amounts of money via IRAs or other retirement accounts, making mistakes with this process can result in paying substantially more taxes than is necessary on your inheritance. In California, you could potentially lose up to half your inheritance to taxes if you do not handle it wisely.

The 3 Categories of Beneficiaries under the Secure Act:

• Non-designated beneficiaries, or NDBs (no named beneficiary). The eventual inheritor will not be able to benefit from the stretch IRA.

• Non-eligible designated beneficiaries, or NEDBs. NEDBs also are not eligible to use the stretch IRA. They will be subject to the 10-year rule.

• Eligible designated beneficiaries, or EDBs. Eligible designated beneficiaries are eligible to use the stretch IRA.

3 Inheritance Mistakes To Avoid

Taking A Lump-Sum Distribution From The IRA You Inherit

If you are fortunate to inherit a large IRA or other retirement accounts, the value of proactive tax planning can be huge. The tax savings could be substantial regardless of whether you can use the old stretch IRA or the current 10-year rule.

For example, let’s assume you will inherit a two-million-dollar IRA. Good problem to have, right? If you don’t implement any tax-planning strategies and withdraw the entire inheritance in a single lump sum, you will get battered by taxes. Depending on your income and marital status, as much as three-fourths of this inheritance could end up in the top federal bracket of 37%. I’m a financial planner living in California, where an inheritance like this would also be subject to taxation as high as 13.3%. That means some or all of your inheritance could get taxed at more than 50%) (again, depending on your total income and where you live).

Spreading withdrawals from an inherited IRA over 10 years can help keep much of your inheritance taxation in lower tax brackets at both the federal and state levels.

To put this more bluntly, income in the top federal and California tax brackets is taxed at 50.3% (37% federal, 13.3% California). That is a tax of $1,006,000 of income taxes. You would likely see other increases in cost if you were on Medicare, have other income, and the 3.8% Affordable Care Act surtax.

Not Understanding The Options For Spouses Inheriting An IRA

There are several options for spouses when inheriting an IRA. They can do a spousal rollover, which means moving the inherited IRA money into an IRA in their name. They can do a stretch IRA or follow the 10-year rule. If the money isn’t needed now, consider doing a spousal rollover. If you need the IRA money to live off today (and are under 59.5 years old), there may be reasons to do a combination of spousal rollover with a stretch IRA.

Mixing Pre-2020 Rules And Secure Act Rules

Perhaps you inherited an IRA when your father passed and assume the rules are the same now that your mother has just passed. This may not be the case depending on when you lost your parents.

Pretty much everything related to tax law is complicated. Throw in new tax rules or changes, and there is almost inevitably confusion. There is a swath of pre-2020 IRA beneficiaries who are being told they are not eligible to benefit from a stretch IRA, which is just rubbish advice. They can still use this option. The Secure Act does not change their payout schedule.

There are also post-2020 inheritors of IRAs who are mistakenly being told they are eligible to stretch their inherited IRAs when they are not eligible. Depending on your overall tax situation, this could mean making taxable withdrawals from your inherited IRA, which could result in high taxation of your inheritance. The wrong advice could also mean you find yourself on the wrong side of painful IRS penalties, which is like leaving the IRS a huge tip.

The biggest hurdle here is people who don’t realize they are eligible designated beneficiaries or EDBs. This group of beneficiaries can still benefit from the stretch IRA regardless of when the deceased passed. Missing this distinction could lead you to the wrong withdrawal schedule, pushing your income into higher tax brackets than necessary and substantially increasing your lifetime tax bills.

Who Is An Eligible Designated Beneficiary

An eligible designated beneficiary (EDB) is always an actual person. In plain English, a trust, charity, estate, or corporation will never be an eligible designated beneficiary. Here are the five categories of individuals who are included in the EDB classification:

1. The retirement account owner’s surviving spouse

2. The retirement account owner’s child who is less than 18 years of age

3. A disabled individual

4. A chronically ill individual

5. Any other individual who is not more than 10 years younger than the deceased IRA owner

In most instances, EDBs can withdraw from their inherited IRAs based on their life expectancy.

Receiving an inheritance can be emotional and stressful. Make sure to seek the guidance of a trust Certified Financial Planner ™ and tax pro to help ensure you understand your options with an inherited IRA and have a plan to minimize taxes on your inheritance.

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