Make the most of your inherited IRA
If you are inheriting a retirement account from a deceased parent, you may be wondering what the rules are or how you can withdraw the funds from this account without incurring excessive taxes.
I’ve discussed the rules in a previous article; in this article I’m focusing on practical strategies to apply these rules.
This article is for educational purposes only, and it is neither tax advice nor investment advice. Consult a professional before implementing these strategies.
How to open an inherited IRA
This guide assumes you have inherited a brokerage account, or an account that holds stocks, bonds, or mutual funds. If you are inheriting an annuity, this likely will not apply to you.
The first step to receiving your deceased parent’s IRA is to open an inherited IRA at a financial institution that will hold the assets. Fidelity, Schwab, and Vanguard are generally considered the best large custodians to work with.
Once the account is open, you will need to work with the institution holding your parent’s account to transfer assets to your newly opened account. Assets can be transferred “in-kind”, meaning the shares of stocks and bonds will transfer to your account. They can also be “liquidated”, meaning the shares will be sold and cash transferred to your account. Whichever option you choose, you will not have to pay taxes until you withdraw the money from your inherited account.
Once the assets are in your inherited account, you can invest and withdraw the money however you want. The rest of this article will give you some tips and best practices to make the most of your inherited IRA.
Here are some things to remember as you work through this process
If your parent was working with a financial professional, you are not obligated to continue working with that person.
You are not required to leave the funds at the same financial institution. Funds can be (and often are) transferred between institutions.
Strategies to use when inheriting an IRA
Comply with the 10-year rule
Most adult children heirs will be subject to the 10-year rule, which states the inherited account must be completely withdrawn by the end of the year containing the tenth anniversary of the account owner’s death.
One strategy is to do nothing for nine years and withdraw the entire account in the tenth. The downside – due to our progressive income tax structure – is that large distribution will likely by taxed higher than if it were split into smaller distributions; in many cases – assuming you inherit the account in the same year as your parent died - you will have 11 calendar years in which you can make a distribution.
A simple strategy to comply with this rule while spreading the tax bill across a decade is to distribute one-eleventh of the account balance in Year 0 (the year the account owner died) and to reduce the fraction each year thereafter – Year 1 will be one-tenth; Year 2, one-ninth, etc.
Below is a table modeling this withdrawal strategy including hypothetical market returns. Because of the growth (and decline) in the account value, the withdrawals change each year but ultimately, they fully draw down the account.
A bonus benefit to this strategy is it will almost certainly satisfy the Required Minimum Distribution (RMD) each year, which is necessary if the account owner was RMD age when they died.
Are you unsure about RMDs in your inherited account? Click here to view and download our inherited IRA flowchart.
Roll funds from the inherited account to your personal account
An inherited retirement account allows you to defer income (and the consequent taxes) for up to 10 years after the original owner dies. A personal retirement account allows you to defer income for your entire life. To maximize your tax deferral, you’d like to move money from the inherited account to your personal account without paying taxes.
While you can’t directly move money from an inherited account to a personal account, you can effectively do this by maximizing contributions to your pre-tax retirement accounts (giving you a tax deduction) and withdrawing an equal amount from your inherited account. The net effect is $0 taxes paid and no change to your take-home pay, and you get the benefit of deferring taxation for the rest of your life (or until you need the money).
This is an illustration of how to effectively move funds from an inherited account to a personal account.
There is a limit to this, of course. If you are under 50 years old, the 401(k) contribution limit is $23,500, and the IRA contribution limit is $7,000. The IRA also has strict income limits which precludes many middle-income taxpayers from utilizing it. If you are over 50, the catch-up contribution allows you to defer an additional $7,500 and $1,000, respectively, to your 401(k) and IRA.
Even with the contribution limit, this is an impactful strategy that allows you to mitigate the taxes of an inherited retirement account, which for many people occurs during their peak earning (and consequently highest-taxed) years.
Withholding taxes from an inherited IRA
This isn’t so much a strategy as it is a necessity. When you pull money from an inherited IRA (except for Roth IRAs), the withdrawal will be taxed as income. Your custodian should have an option for you to withhold a certain percentage of your distribution for federal income tax, just like your employer does. If you do not withhold taxes on distributions and you do not increase your withholding from your paycheck, you may face a large tax bill and/or an underpayment penalty when you file taxes next spring.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
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