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As the wealth in America has grown significantly, so has the age of the U. S. population. It is becoming more and more common for individuals to inherit retirement accounts from their loved ones. Due to this confluence of factors affecting our population, it has become increasingly important to know what steps to take as an heir to such inherited accounts to avoid making costly mistakes.
The reality of the situation is, there are several options when talking about inherited accounts, those options depend on a variety of factors including your relationship to the original account holder, the age of the original account holder when they passed away and the type of account you’ve inherited. Here are four crucial steps to follow to increase your benefits in the long run:
Step 1: Title the New IRA
The first step you want to take when you inherit an IRA will be to make sure it's set up correctly. An inherited IRA should have two critical components:
- Have the deceased original owner's name.
- It should indicate that the IRA was inherited.
Alternatively, if the account was inherited from a spouse, you can do a direct rollover into your own IRA account. If this is something you plan to do, keep in mind that it takes time to set up new accounts and if you plan to transfer any distributed money to a new account in your name, you must do so within 60 days.1
If you are the beneficiary of an IRA from someone other than your spouse, you will not be able to combine the inherited money into your own retirement account. In order to keep the tax benefits of the inherited account, you will need to set up a new Inherited IRA for Benefit under your name.2 After the account has been created, you’ll be able to transfer assets from the original account to your beneficiary IRA.
Step 2: Calculating the Right Distribution Amount
If you’re a spouse of the deceased, you will be able to stretch the required minimum distributions (RMD's) over your own life expectancy. To calculate this RMD, you will need the prior year-end account value and life expectancy to figure out what the proper distribution amount is. This calculation is always based on the account value from the end of the previous year. For example, in order to calculate distributions for the year 2019, the account value on December 31, 2018, is used.
If you are a non-spousal beneficiary, it’s important to understand that you will have to withdraw every dollar from the account, in its entirety over the course of 10 years, if the deceased passed on or after January 1, 2020.3 This is a new rule since the passing of the SECURE Act in 2019. Prior to the SECURE Act, the IRA amount was allowed to be withdrawn throughout the beneficiary’s remaining life expectancy -For example, if you were 50 years old when you inherited the IRA, and your life expectancy was 82, you could slowly withdraw this money over 32 years.
It's not all bad news though, one thing the SECURE Act does not stipulate is how much you have to withdraw from the account in any given year.3 This makes it more important than ever to understand your income and tax bracket. In a year like 2020, when we had a global pandemic and economic crash, it's quite possible your income was negatively impacted. If your salary is lower than normal, it's important to identify these opportunities to possibly withdraw more money from the account without pushing yourself into a higher tax bracket.
Step 3: Determine If the IRA Has an After-Tax Basis
Most beneficiaries are either unaware or unwilling to find out if the IRA they’ve inherited has an after-tax basis. If you have inherited an IRA and you find out that it has an after-tax contribution you should fill out a Form 8606.4 By completing this form you’ll be able to claim the non-deductible portion of the required minimum distribution without a tax consequence.
You can always ask the executor if they are aware that the IRA has an after-tax contribution, but they might not know themselves and will need to refer to the tax returns of the deceased to learn if they filled out the form previously.
Step 4: Make a Plan for the Taxation of Distributions
Taxation of distribution is different for Roth IRAs and other IRAs. In many cases, Roth IRAs have distributions that are tax-free unless the Roth IRA was not open and had contributions, for at least 5 years prior to the decedent's death. However, for other IRAs, the distributions are fully taxable as ordinary income, unless the original IRA owner had a tax basis in their IRA. If you determine the distributions will be taxable, you will definitely want to do a tax projection where you include the taxable portion of the distribution, this way you can find out the proper amount to withhold and avoid being hit with a larger than expected tax bill at the end of the year.
As you make a plan for distribution, it's important to understand how all of the nuances like titling, the SECURE Act, and taxes will impact you. We want to help you avoid making those costly errors, meet with a knowledgeable advisor as soon as you learn that you have inherited an IRA. Unfortunately, mistakes could mean larger taxes and complexities in the long run.
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|About the Author
James M. Comblo , CFF
is a Partner and the Chief Compliance Officer at FSC Wealth Advisors. His greatest passion in the financial services industry is helping clients accomplish their dreams both with investments and their personal lives. To learn more about him click here.
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