Getting Smart About Inherited IRA's

By Liza Hanks
Finch Montgomery Wright

I work hard to make sure that my clients name beneficiaries for their retirement accounts properly. I want them to make sure that their loved ones have the option of taking money out of those inherited IRAs slowly over their estimated life expectancy, so that they can get the maximum tax benefits from deferring the income tax due on those withdrawals. And yet careful planning doesn't matter if the beneficiary turns around and just withdraws all of the money from that account shortly after inheriting it. And many people do just that. If you have inherited an IRA, here's an article that helps clarify why taking money out slowly is a much better idea.

Here's an example: One of my clients was just informed that when her father died, a few months after the death of her mother, her father left her his IRA and her brother a vacation home worth $200,000. At the moment, there is $200,000 in the IRA, the same amount as the current appraisal of the cabin. My client is a little disappointed, thinking she would have preferred the cabin, until she sits down with her tax specialist who explains to her that she, in fact, got the better deal.

How the IRA is better than the Cabin

Assume all estate taxes have been paid for both the IRA and the cabin. Since her brother inherited the cabin at his father's death, he received it at the stepped-up basis of $200,000, and therefore, would not owe any capital gains taxes on the sale of the cabin. Assuming his selling costs are 6%, he walks away with $188k and invests the proceeds for the next 20 years.

Similar to his sister, he takes an annual withdrawal equal to her RMD requirement (roughly 3% for a 50 year old beneficiary and increasing each year) for the inherited IRA. They both earn 6% annually. However, he has to pay income taxes annually on his investment while his sister does not. She only has to pay income taxes on the RMD withdrawal.

If they both own mutual funds with a similar allocation and we assume their federal and state taxes are around 35%, then over 20 years, his assumed rate of return is roughly 4% (the impact of paying taxes) Meanwhile, his sister is receiving an annual income of 35% less than her brother (because her RMD is taxable), but her principal of $200,000 is growing at 6% every year. At the end of 20 years, his principal balance is just under $250,000 while his sister has just over $425,000. Of course, there are many factors that can impact their actual returns along the way but the key point is that tax-deferral is powerful especially when it comes to inherited IRA's.

Basic definition of a “stretch” IRA?

A stretch IRA is not a product, but a strategy allowed by the IRS to “stretch” the life of an inherited IRA down through generations. This allows beneficiaries to withdraw a certain amount of funds from the account over many years. The funds left in the account continue to accumulate on a tax-deferred basis.

What are some of the rules?

In order to maintain the tax-deferred status of an inherited IRA, the beneficiary must rename it. The plan administrator will let a beneficiary know exactly what their options are with respect to withdrawals. Although the IRS sets out the rules, not all plan administrators offer all permissible options under those rules, so some of this is a case-by-case determination.

Some rules that apply to IRA stretching include:

  • Verification in writing that the institution where the IRA is located allows for IRA stretching. If not, move it to one that does. This must be done by the end of the year following the year the original owner of the IRA died.

  • The IRS has an annual required minimum distribution (RMD) of the IRA. If the original owner died after age 70 ½, the beneficiary, as the heir, must take the amount of the owner’s RMD in the year of the death.

  • The amount of the RMD a beneficiary is required to take depends on their age at the time they inherit the IRA. The IRS has a life expectancy chart that estimates how much longer that beneficiary will live and determines how much money they must withdraw from the IRA every year. For example, a 40-year-old has a life expectancy of 43.6 years. A 65-year-old is expected to live another 21 years. The total amount of money in the account is divided by the life expectancy years to determine the annual RMD.

  • Based on the RMD formula, the younger a person is when they inherit, the less the amount of their RMD.

  • Heirs pay income taxes on the amount of the distribution.

  • The remaining balance in the account accumulates tax free.
Importance of having a good financial adviser

There are complex rules governing inherited IRAs. Congress frequently revisits the issue and may make some tweaks in current law.

Heirs may also consider disclaiming the inheritance in favor of a secondary or contingent beneficiary if that beneficiary happens to be a child or grandchild. Since they would have a longer life expectancy, their RMD would be much less, which would allow more money to stay in the IRA and accumulate on a tax-deferred basis. Tax on distributions are different for Roth IRAs than for traditional IRAs.

If you have questions about inherited IRA's, feel free to get in touch. You can email me at lhanks@fmwlaw.com or call me at 650/327-0088. You can also download my book, The Family's Guide to Wills and Estate Planning, for free.