Saving for retirement has changed throughout the years. While it used to be far more common to have pension income, we are now forced to save and then manage our own funds. According to the Merrill Edge Spring 2018 Report, nearly one in three families believe that their financial stability will rely on receiving some kind of inheritance. While we will always try and help build financial independence, inheriting wealth in the right way can make a significant difference in your plan.
For those of you who are fortunate enough to expect an inheritance, one of the vehicles that may be passed on to you is an IRA. An IRA is unique because it will have its own set of beneficiaries named which can be independent of what a will or trust may say. It is important to make sure these beneficiaries are set up correctly ahead of time. We often encounter situations where only one person was named and is expected to split up the assets which results in many negative tax consequences.
For those who are married, typically your spouse is named as the primary beneficiary. When it comes to inheriting a spouse’s IRA, the rules make it simple and effective to inherit the assets. Typically, the best course of action is to roll the deceased spouse’s IRA into the surviving spouse’s IRA. This can be an existing IRA or a newly created one for this purpose. Going forward the IRA is treated the same as your own. The surviving IRA will be subject to the normal age rules, waiting until 59 and a half to begin withdrawals (without penalty) and required minimum distributions starting at 70 and a half.
For non-spousal beneficiaries, the rules are slightly different. You are not able to roll the inherited IRA into your own IRA. There are a number of options, but really only one good one, especially depending on the size of the IRA. Many will go ahead and take a direct distribution of their inheritance. That can be very expensive as it will all be taxed as ordinary income on top of what you have already earned that year. It also loses all the benefits of being in a tax-deferred vehicle.
The better choice is to set up a beneficiary IRA account and roll the funds over into it. Using a beneficiary IRA will allow you to stretch out the distributions over multiple years and potentially even your entire lifetime. Each year you will have to take out a portion of the IRA based on the value at the end of the previous year. This amount will be based on an IRS-provided factor and is typically a few percentages depending on your age. You will now have the same tax-deferred benefits as the original owner and it is a great way to supplement your own retirement savings.
For those of you who are wanting to leave an IRA as an inheritance, there are a couple of steps to help make the transition easier for your beneficiaries. Always keep your beneficiaries up to date. If you don’t remember who you set up, reach out to your advisor or custodian and ask. Also, if legacy is a goal, consider converting at least some of your IRA to a Roth IRA. By paying the taxes now, you can let it grow tax-free for the rest of your life and the beneficiary’s life. They will also not have to take out the small portion every year.
If you have any questions or are trying to inherit an IRA, please never hesitate to reach out and ask for help from us here at Cedarstone to make sure you are doing it correctly.