Protecting your assets
3 mistakes beneficiaries need to avoid when inheriting an IRA
Tax law changes in the Secure Act have eliminated the stretch IRA for most beneficiaries inheriting an IRA or 401(k). Most beneficiaries who inherit an IRA will now need to follow the 10-year rule, which can significantly increase the income taxes due on an inheritance.
The good news is that stretch IRAs are still available for spousal beneficiaries. For most non-spouse beneficiaries (think children, friends), the stretch IRA option has been replaced with a new 10-year payout rule. This rule required that IRA beneficiaries completely 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.
For those who already had an inherited IRA before 2020, don’t freak out; you can still follow the old stretch IRA rules. This will allow you to take required minimum distributions from your inherited IRA over your lifetime. Likewise, 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 just transfer the inherited IRA into an IRA in their names alone.
It is imperative that you recognize into which category of beneficiary you fall. That will determine the inherited IRA payout options available to you. For those receiving substantial inheritances via IRAs or other retirement accounts, making mistakes with this process can result in paying substantially more taxes than is necessary.
• non-designated beneficiaries, or NDBs (no named beneficiary). The eventual inheritor will not have the ability 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.
For those fortunate to inherit a large IRA or other retirement accounts, the tax saving from both the old stretch IRA and the current 10-year rule could be substantial.
For example, let’s assume you are going to inherit a two-million-dollar IRA. If you ignore smart tax planning and pull out the entire inheritance in a single lump sum, you will get walloped by taxes. Depending on your own 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 in California, which would also be subject to additional state taxation as high as 13.3%. Spreading withdrawals over ten years can help much of your inheritance’s taxation in lower tax brackets at both the federal and state levels.
In case this isn’t clear, 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, as well as the 3.8% Obamacare surtax.
There are several options for spouses when inheriting an IRA. They can do a spousal rollover, which essentially means moving the inherited IRA money into an IRA in their own names. They can do a stretch IRA, or they can follow the 10-year rule. Typically, if the money isn’t needed now, you should look at 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.
Tax law is complicated enough, but when tax rules change, 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.
On the flip side of this, there are post-2020 inheritors of IRAs who are mistakenly being told they are eligible to stretch their inherited IRAs when they are not actually 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 biggest hurdle here is people who don’t realize that they are eligible designated beneficiaries or EDBs. This is the group of beneficiaries who can still benefit from the stretch IRA regardless of when the deceased IRA owner passed. Missing this distinction could lead you to the wrong withdrawal schedule pushing your income into higher tax brackets than necessary and increasing your lifetime tax bills substantially.
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 ten years younger than the deceased IRA owner
In most instances, EDBs will be able to withdraw from their inherited IRAs based on their own life expectancies.
Receiving an inheritance can be emotional and stressful. Make sure to seek the guidance of a trusted Certified Financial Planner™ and tax pro to help ensure you understand your options with an inherited IRA as well as have a plan to minimize taxes on your inheritance.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.
Get in touch with The Private Bank
Build a financial partnership to last a lifetime.