Let’s face it. Inheriting an IRA can be a stressful time in people’s lives. Understandably, we are usually busy and distracted, which is when it is easiest to make a simple mistake. When inheriting an IRA, these types of mistakes can end up becoming very costly. There are different rules for spouses who inherit an IRA and for everyone else who inherits an IRA. We will be looking at 4 mistakes you want to avoid as a non-spouse beneficiary when going through this process.
Not Taking a Required Minimum Distribution
Most people know that once they reach the age of 70 ½ they are required to withdraw money from their IRA. While this is the case with their Traditional IRAs, an Inherited IRA is treated differently. The IRS requires that the person inheriting an IRA, take withdrawals over a specified period-of-time, at least annually. This could be all at once (known as a Lump-Sum), over the course of five years (known as the 5-year rule) or based on the inheritor’s (also known as a beneficiary) estimated lifespan. A beneficiary can always choose the Lump-Sum option, however, whether they must withdraw the funds within 5 years or over their lifetime, will depend on whether they were named as a beneficiary on the account. (This is an issue we will explore in a later posting). The timeframe will determine how much you will need to withdraw each year. My advice: set a reoccurring reminder in your calendar to make sure this is done annually.
Contributing to an Inherited IRA
Unlike a Traditional IRA, you are not allowed to contribute to an Inherited IRA. If you do so unwittingly, the account will no longer be considered an Inherited IRA and the entire account will be taxable all at once! Think of it: You inherit $1 million dollars and accidentally contribute to your Inherited IRA instead of your Traditional IRA. If your investment firm doesn’t catch the mistake, the entire $1,000,000 balance has just become taxable. This mistake would push you into the highest tax brackets and could cost you $370,000 or more in federal taxes not to mention any state taxes you may have to pay! Do yourself a favor and make sure you keep your IRA’s separate and distinct.
Withdrawing Your Money Using an Indirect Rollover
Now you may be asking yourself, “What is an indirect rollover?” Glad you asked! An indirect rollover is when the account holder transfers assets from one qualified account to another and is the one responsible for ensuring the money transfers within the 60-day window. What can be confusing is that you can use the method once a year with your own Traditional IRA. This is not the case with Inherited IRAs! Doing so will make the entire account taxable and could create a large unexpected tax bill (see previous example). One important caveat is that spouses can use this method if the funds are replaced in that 60-day window. However, all non-spouses must use a direct transfer if they wish to continue deferring taxes on the account.
Taking a Lump-Sum
While this isn’t always a mistake, in most cases, it is usually beneficial to “stretch” the withdrawals over your lifetime. Often referred to as a “Stretch IRA”, this technique allows the beneficiary to use their lifespan to determine withdrawal rates. This can be beneficial in a couple of ways. The first, is it allows the remaining funds to continue to grow and compound in a tax-deferred environment (meaning no taxes are due until they are withdrawn). This compounding effect can be very beneficial over a period of years as money can grow at a faster rate when not burdened with yearly taxes. Secondly, it spreads the tax liability out over a lifetime. Since we have a progressive tax system, meaning the last dollar earned has the highest tax rate, the more you pull out at once, the higher your tax rate will be.
Example: You are retiring this year and want to pay off your mortgage (seems like a great idea!). You recently inherited an IRA with $400,000 and want to use the money to be debt-free. While this is a noble goal, you may have just created yourself a very large tax liability. By withdrawing this money all at once, you have put yourself in the 35% federal bracket if you are married, 37% if you are single, and probably at the top of your state income tax bracket if you have one. This means that out of the $400,000 you just withdrew from your account, nearly half of it will go to Uncle Sam! It would be worth your time to explore whether “stretching” your withdrawals out over your lifetime, would increase your retirement lifestyle and save you money.
Remember, these mistakes are easy to avoid and there is help if needed. Be sure to consult your CPA, Tax Advisor or Financial Advisor if you have any questions or need advice for your situation. Our Financial Advisors are ready to assist with your IRA questions.