Inherited IRA Stategies
Published On: April 15, 2021
Written by: Ben Atwater and Matt Malick
After the passage of the SECURE Act, and beginning January 1, 2020, the rules for inherited IRAs changed considerably.
Whereas someone who inherited an IRA prior to 2020 could stretch the distributions over their lifetimes, they now only have ten years to take the distributions.
Generally, a beneficiary is required to liquidate the account by the end of the 10th year following the year of death of the IRA owner (the 10-year rule). During the 10-year period, the beneficiary may take (taxable) distributions of any amount at any frequency.
There are exceptions for certain eligible designated beneficiaries: the IRA owner’s spouse, the IRA owner’s minor child, an individual who is not more than 10 years younger than the IRA owner, and someone who the IRS defines as disabled and / or chronically ill.
Since an IRA beneficiary must withdraw the total amount of the IRA within ten years, an IRA is a less desirable asset to bequeath to younger beneficiaries, potentially motivating the IRA owner to spend more of the IRA account during his lifetime.
This has always been antithetical in financial planning doctrine. But, now that the tax deferral of an IRA has a much shorter life expectancy – the life of the owner plus ten years, in many cases – we can now argue in favor of spending smaller amounts over more years to spread out the tax burden.
This approach can control taxes and marginal tax rates during any given calendar year since regular and inherited IRA withdrawals are federally taxable as ordinary income. (Roth IRA distributions are not taxable.)
Therefore, as an example, it may make more sense for someone over 70 and 1/2 years of age to give a charitable gift from their IRA as a Qualified Charitable Distribution (QCD) than it does to give appreciated stock.
Also, it makes even more sense to delay Social Security until 70 and supplement retirement income from IRA funds, particularly if the stock market remains strong. In other words, take your distributions earlier and over more years.
In certain cases, like a depressed stock market, a year with limited income, a large charitable gift, a huge healthcare expense, etc., Roth IRA conversions might be sensible.
If you plan to leave money to charity, the IRA should be the first funds you designate, not a life insurance policy and not a bequest in your will.
When you do ultimately pass IRA dollars to beneficiaries, what is the best withdrawal strategy assuming the 10-year rule applies? This is an important question because the IRS also taxes these beneficiary withdrawals as ordinary federal income.
The starting point should be to divide the initial inherited balance by ten and take that amount every year.
If the stock market is particularly strong any given year, you should take more. For example, the original ten percent plus the appreciation that year.
If the market is down markedly you may opt to take substantially less or even nothing, so the account has a chance to recover and then make up the withdrawals after the market recovers.
Aside from the factor of market performance – take more money in up years and less money (or no money) in down years – there are a host of other factors to consider as well.
If you have a year where your income has fallen, a year where you make a large charitable gift, a year when you have a large income tax deduction, etc., you have the opportunity in these years to take more from the inherited IRA.
If you are already financially successful and are in the highest income tax bracket every year, you may decide to take the full IRA balance in the tenth year. After all, the funds would be taxed at the highest marginal bracket regardless. And this would allow the funds within the IRA to compound tax free over a decade providing the potential for meaningful growth.
There is now plenty to think about around IRAs and beneficiaries. Much more than a few years ago. Please do not hesitate to call on us to discuss this important issue.