Understanding Inherited IRAs

Understanding Inherited IRAs

Rules, RMDs, and a Strategic Case Study

Inheriting a qualified retirement account (401k,403b, Traditional IRA, etc.) can be bitter sweet. The only way to inherit an IRA is by loosing a loved one, and money can never replace that person. But your loved one named you beneficiary of the account because they wanted to add to your quality of life. But inheriting and IRA comes with complex tax rules and withdrawal requirements that can catch beneficiaries off guard. Whether you're navigating the 10-year depletion rule or managing Required Minimum Distributions (RMDs), understanding the implications of an inherited IRA is crucial for maximizing its value while staying compliant with IRS regulations. Below, we’ll break down the key rules, explore the impact of RMDs if the original owner was taking them, and share a real-world case study of a client who used an innovative strategy to manage an inherited 401(k) effectively.

What Is an Inherited IRA?

An inherited IRA is a retirement account passed to a beneficiary after the original owner's death. This could be a Traditional IRA, 403b, 401k that is rolled into an inherited IRA. The rules governing inherited IRAs depend on the beneficiary’s relationship to the deceased, the type of account, and whether the original owner was taking RMDs.

Key considerations include:

• Tax Implications: Withdrawals from traditional inherited IRAs are generally taxable as ordinary income, while Roth IRA withdrawals may be tax-free if the account met certain conditions.

• Withdrawal Rules: The SECURE Act of 2019 introduced significant changes, particularly the 10-year rule, which affects how quickly beneficiaries must deplete the account.

• RMD Requirements: If the original owner was taking RMDs, the beneficiary may also need to take annual RMDs, depending on their status.

Understanding these rules is essential to avoid penalties and optimize the inherited assets for your financial goals.

The 10-Year Rule for Inherited IRAs

Under the SECURE Act of 2019, most non-spouse beneficiaries of an inherited IRA must withdraw all funds within 10 years of the original owner’s death. This applies to accounts inherited on or after January 1, 2020. However, the specifics depend on the beneficiary’s classification:

• Eligible Designated Beneficiaries (EDBs): Certain beneficiaries, such as surviving spouses, minor children (until age 21), disabled or chronically ill individuals, or those not more than 10 years younger than the deceased, may have more flexible options, such as taking distributions over their life expectancy.

• Non-Eligible Designated Beneficiaries: Most adult children, other relatives, or unrelated beneficiaries fall into this category and must follow the 10-year rule, depleting the account by the end of the 10th year following the original owner’s death.

Does the Account Need to Be Depleted Within 10 Years?

For non-EDBs, yes, the entire account must be withdrawn by December 31 of the 10th year after the original owner’s death. However, the IRS clarified in 2022 that if the original owner was taking RMDs (they were 73 or older at death), the beneficiary must also take annual RMDs during those 10 years, based on their life expectancy. These RMDs count toward the 10-year depletion requirement, but the remaining balance can be withdrawn at any time before the deadline.

If the original owner was not yet required to take RMDs (i.e., under 72), beneficiaries subject to the 10-year rule generally have flexibility to take distributions at their discretion within the 10-year window, without annual RMDs.

Implications of RMDs on the Inheritor

If the original owner was taking RMDs, the implications for the inheritor include:

1. Annual RMD Obligations: The beneficiary must continue taking RMDs each year, calculated based on their own life expectancy using the IRS Single Life Expectancy Table. These distributions are taxable and must begin by December 31 of the year following the owner’s death.

2. Tax Impact: RMDs are treated as ordinary income, potentially pushing the beneficiary into a higher tax bracket, especially if they have other income sources or take large distributions.

3. 10-Year Deadline: In addition to annual RMDs, the entire account must still be depleted by the end of the 10th year, which may require strategic planning to minimize tax burdens.

4. Penalties for Non-Compliance: Failing to take required RMDs incurs a 25% penalty on the amount that should have been withdrawn.

These rules highlight the need for a proactive strategy to manage inherited IRAs, balancing tax efficiency, compliance, and long-term financial goals.

Case Study: Turning an Inherited 401k into Tax-Free Retirement Income

To illustrate how we navigated these rules recently, let’s explore a recent client case that showcases a creative solution for managing an inherited 401(k).

Client Background

Our client, Amy (name changed for privacy), lost her father in May, who named her as beneficiary of a 401k worth $100,000. Amy's father was taking RMDs at the time of his death, meaning Amy was subject to both the 10-year depletion rule and annual RMD requirements. As a busy professional with significant qualified retirement assets of her own, our client had three primary goals:

1. Comply with IRS Rules: Meet the 10-year depletion requirement and annual RMD obligations without penalties.

2. Build Tax-Free Retirement Income: Leverage the inherited funds to fund a Roth IRA.

3. Minimize Risk and Management: Avoid market risk and active management of withdrawals due to her demanding schedule.

The Challenge

Amy knew she had to liquidate the $100,000 401(k) within 10 years and take annual RMDs, which would be taxable. However, adding these distributions to her income could increase her tax liability, and she was concerned about market volatility impacting the account’s value. She also wanted to start contributing to a Roth that way she can have tax free income in the retirement. And to wrap it up she wanted a hands-off approach to simplify the process.

The Solution: Rolling into a 10-Year Period Certain SPIA

After assessing Amy's goals, we proposed rolling the inherited 401(k) into a qualified 10-year period certain Single Premium Immediate Annuity (SPIA). Here’s how it worked:

1. Rollover to an Inherited IRA: The $100,000 401(k) was transferred into an inherited IRA, maintaining its tax-deferred status and allowing compliance with IRS rules for inherited retirement accounts.

2. Purchasing the SPIA: The $100,000 was used to fund a 10-year period certain SPIA, which guarantees equal annual payments over 10 years, fully depleting the account by the end of the term to meet the 10-year rule.

3. Automating RMDs: The SPIA’s annual payments are structured to satisfy the IRS’s annual RMD requirements, calculated based on Amy's life expectancy. These payments will be automatically deposited into her bank account, requiring no active management.

4. Funding a Roth IRA: Each year, Amy will use the SPIA payments to fund her Roth IRA. This allowed her to convert taxable distributions into a tax-free retirement asset, as Roth IRA withdrawals are tax-free in retirement.

5. Eliminating Market Risk: The SPIA provided fixed payments, shielding the funds from market volatility and aligning with Amy's preference for stability.

The Outcome

• IRS Compliance: The SPIA ensured the inherited 401(k) was fully depleted within 10 years, and annual payments met RMD requirements, avoiding penalties.

• Tax-Free Growth: By funding her Roth IRA annually, Amy built a tax-free retirement asset, leveraging the inherited funds for long-term financial security.

• Simplicity and Peace of Mind: The automated SPIA payments eliminated the need for Amy to monitor withdrawals or market performance, complimenting her busy lifestyle.

Why This Strategy Worked

This approach was ideal for Amy because it:

• Addressed the 10-year rule and RMD obligations seamlessly.

• Converted taxable distributions into a tax-free Roth IRA, optimizing her retirement plan.

• Provided predictable, risk-free income through the SPIA, reducing stress and management effort.

Key Takeaways for Managing an Inherited IRA

1. Understand the 10-Year Rule: Most non-spouse beneficiaries must deplete an inherited IRA within 10 years, with annual RMDs required if the original owner was taking them.

2. Plan for Taxes: Distributions are taxable, so consider strategies to spread withdrawals or redirect funds into tax-advantaged accounts like a Roth IRA.

3. Explore Creative Solutions: Tools like a period-certain SPIA can automate compliance, reduce risk, and align with your financial goals.

4. Consult a Financial Advisor: Inherited IRA rules are complex, and personalized strategies can help you maximize the account’s value while minimizing taxes and penalties.

How to Get Started

If you’ve inherited an IRA, don’t let the complexity of IRS rules overwhelm you. A financial advisor can help you navigate the 10-year rule, RMD requirements, and tax implications while tailoring a strategy to your unique needs.