What Happens when You Inherit a Retirement Account?

What Happens when You Inherit a Retirement Account
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There’s almost always a reckoning when the government proffers a tax break. So it is with individual retirement accounts (IRA)s, 401(k)s, and similar accounts that investors fund with pre-tax earnings.

The SECURE Act of 2019 reset the game for IRAs and other tax-deferred retirement accounts, says a recent article from Financial Advisor titled “IRAs, Taxes and Inheritance: Planning Becomes a Family Affair.” Before SECURE, investors paid ordinary income tax rates on withdrawals, whether voluntary or Required Minimum Distributions (RMDs), from these accounts, except for Roths. When individuals stopped working, and their income dropped, so did the tax rate on their withdrawals. All was well.

Then the SECURE Act came along with good intentions. The period for payouts of IRAs and similar accounts after the account owner’s death changed. Non-spouse beneficiaries now have only ten years to empty the accounts, setting themselves up for potentially huge tax bills, possibly when their incomes are at peak levels. What can be done?

Heirs of individual investors or couples with hefty IRAs and investment accounts are most likely to face the consequences of the new tax regulations for RMDs and inheritances from the SECURE Act.

A widowed spouse faces the lower of their own or the partner’s RMD rate—it’s tied to birth years. However, a pitfall exists: the widowed spouse files a single tax return, which cuts available deductions in half and changes tax brackets. Single or married, consider accelerating IRA withdrawals as soon as taxable income lowers early in retirement. Taking withdrawals from IRAs at this time voluntarily often means the ability to defer and, as a result, optimize Social Security benefits to age 70.

For non-spousal beneficiaries of inherited IRAs, there’s no way around that 10-year rule. Their tax rates will depend on income, whether they file single or joint, and any deductions available. If a beneficiary dies while the account still owns the assets, those assets may be subject to high estate taxes.

Here’s where tax planning could help. With tax consequences in mind, IRA owners may try to “equalize” inheritances among heirs. For instance, a lower-earning child could be the IRA beneficiary, while a higher-earning child could receive assets from a brokerage account or Roth IRA. Alternatively, an IRA owner could establish trusts or make charitable bequests to empty the IRAs before they become part of the estate.

Another strategy, if you don’t expect to exhaust your IRA assets in your lifetime, is to systematically withdraw money early in retirement to fund Roth IRAs, known as a Roth conversion. The advantage is simple: inherited Roth IRAs must be drawn down in ten years, but the money isn’t taxable to beneficiaries.

Reference: Financial Advisor (Sep. 29, 2022) “IRAs, Taxes and Inheritance: Planning Becomes a Family Affair”