The passage of the SECURE Act in late 2019 brought about broad changes to the United States retirement system for both employees and employers. A major casualty of this bill was the stretch provision for Inherited IRAs. Non-spousal beneficiaries are no longer required to take a minimum distribution from these accounts each year. However, they must now withdraw the entire balance of these IRAs within ten years. To optimize their inheritance, beneficiaries should discuss the following considerations with their advisory team before taking distributions.
First, beneficiaries should clarify their intentions for the money they are receiving. Is there a specific goal for how the money should be spent? (Children’s education, annual vacation, personal retirement.) Does the beneficiary have an immediate need for the funds? (Home repair, hospital bills, expensive debt.) Will the funds be reinvested into other investments? It can be easy to spend money; developing a written plan for an inheritance helps ensure a beneficiary is utilizing their inheritance in accordance with their personal intentions and goals. Life events can be uncertain – having a plan in place serves as a baseline to return to during turbulent times, avoiding short-term decisions that are not aligned with long-term goals.
Confirm if you’ve inherited a traditional or Roth IRA
After defining their goals for the inheritance, beneficiaries should confirm if they have inherited a traditional or Roth IRA. Taxes are paid either by the benefactor when the money is deposited, or by the beneficiary when the funds are withdrawn. Traditional IRA contributions are taxable to the beneficiary when they take a distribution, because the benefactor made pre-tax contributions..
Taking distributions from an inherited Roth IRA
Roth IRAs work the opposite way, taxes were paid by the benefactor at the time of contribution, and there is no tax owed when the beneficiary takes a withdrawal. Roth IRA beneficiaries with long-term goals may consider letting their inheritance grow tax-free until the tenth year then withdrawing the full amount in a lump sum because they do not have to pay taxes on those funds until that time.
Taking distributions from a traditional inherited IRA
The way in which a beneficiary of a traditional inherited IRA takes distributions from that IRA can save taxes over the ten-year distribution period. If a beneficiary distributes the entire balance of the inherited IRA when they take possession of the assets, they may be pushed into a higher tax bracket for that year. This would result in the beneficiary’s income over the threshold amount to be taxed in the higher bracket. While a beneficiary benefits from certainty in the amount they withdraw, they may pay more in taxes.
If a beneficiary distributes the entire portfolio at the end of ten years, they may be faced with a similar tax situation. During the ten-year period, the account can be invested in a diversified portfolio of equities and fixed income, with a reasonable probability of tax-deferred appreciation which may offset the additional taxes paid in the higher tax brackets. Waiting can expose the beneficiary to a variety of risks, including changes in tax policy, changes in income, and systematic investment risk.
Spacing out distributions over 10-year period
A beneficiary may consider spacing out distributions over the ten-year period to benefit from tax-deferred appreciation while also managing taxes. If the beneficiary retires during those years, waiting to take distributions until then may lower the overall tax bill. Another method is to use taxable distributions to “fill up” the marginal tax bracket each year, but avoid moving into the next, higher bracket. These methods can also address changes in tax policy, income, or investment conditions as they occur.
The timing of when a beneficiary takes taxable distributions from an IRA is an important consideration. Developing a tax projection with their financial planner and/or accountant can assess future income and deductions year by year as well as estimate related tax costs over the ten-year period to determine the best withdrawal approach.