We have all seen the headlines: Baby Boomers are set to pass somewhere between $60-75 trillion — depending on the study — to their heirs over the next 20 or so years. In other words, we are set to witness the largest generational wealth transfer of all time.
It is also said that most of that wealth is held in employer-sponsored retirement accounts like 401(k)s and Individual Retirement Accounts (IRAs). With that in mind, it is a safe bet that the IRS is licking its chops waiting to get its hands on those inherited assets before they flow to their intended beneficiaries, but it does not have to be that way.
By understanding the rules around inherited retirement assets — preferably with the help of a qualified tax professional — Gen Xers and Millennials will be better equipped to avoid costly mistakes, like early withdrawal penalties. The more assets inheritors are able to keep, and ultimately defer from taxation, the more successful this massive wealth transfer will be.
Suppose a high-income earner just inherited $500,000 in an IRA and has opted for a lump-sum distribution. Now, suppose that his annual household income is $250,000. This brings his total gross annual income to $750,000 for that year and ultimately places him in the 37% federal income tax bracket. Suppose again that he is an age younger than 59½ years old, the inheritor in this example is automatically faced with an immediate early withdrawal penalty of 10%. In this instance, a total of 47% of the inheritance goes to the IRS before the state has even had its say.
Fortunately, there is no tax bite in no-tax states like Florida, Pennsylvania, and Texas. However, living in high-tax states like New York or California could mean that inheritors end out forking over more than they even get to keep.
So, we have the problem, now what is the solution?
Unfortunately, the answer is not as straight forward as the question. The solution depends on whether the inheritor is the spouse of the decedent or not, as the rules for non-spouse beneficiaries are more complicated than the rules that govern spouses. I will tackle those rules separately. Parenthetically, there are a separate set of rules for inheriting a Roth IRA or Roth 401(k). Those will not be addressed here, but it’s important to know that they exist.
A beneficiary who is also the spouse of the deceased has the right to roll the inherited retirement funds into an IRA in their own name and continue to defer taxes on those funds until it is time to take Required Minimum Distributions (RMDs). This tends to be a rather straightforward process and should involve little-to-no hassle. Keep in mind that inherited funds received via check must be deposited into an IRA in the beneficiary’s name within 60 days to avoid a costly penalty.
When it comes to non-spouse beneficiaries, however, the process is not as straightforward. The beneficiary is given the option to take a lump sum distribution or roll the funds into an inherited IRA titled in their name. Taking a lump sum is self-explanatory, so I will not expound upon it other than to give the following warning: Be prepared to give a hefty sum to the tax man.
As for the folks who choose to defer their inheritance, hopefully for their own eventual retirement, there is an option called the “Inherited IRA”; this is sometimes referred to as a “beneficiary IRA.” This IRA account may be established at any of the large brokerage firms either online or by working through a financial advisor. Inherited IRA accounts must bear the name of the beneficiary and must contain explicit wording that designates the funds as being inherited. The decedent’s name and the date of death must also be clearly indicated. Making a mistake in the set-up of this account could cost big time, so be sure to pay attention to the details.
After the bequeathed account is carefully and correctly rolled over to a properly titled inherited IRA, funds can be distributed from it each year with minimal tax consequences in the form of RMDs. Those RMDs can be stretched out based on the IRS’s predetermined life expectancy of the beneficiary, while any remaining funds are allowed to continue to grow tax-deferred. However, beware that failure to take a required distribution could result in a hefty tax penalty equal to 50% of the amount that should have been distributed that year. So, be sure to set an annual RMD reminder somewhere if going it alone.
Nonetheless, the goal here is to make sure that as many of these inherited funds go to their intended beneficiaries and do not fall into the hands of the IRS. Every situation is different. So, it may be best to, stop, take a beat, and consider consulting a professional who is knowledgeable of the latest regulations regarding inherited retirement assets.
Final pieces of helpful information:
Jumping the gun and taking cash out of the account before it has been properly established as an inherited IRA and then rolled over could be costly.
IRS tax rules forbid contributions to be made into an inherited IRA. Any inherited funds must be kept separate from other previously owned IRA accounts.
If there are multiple beneficiaries of the same retirement account, each beneficiary will need to establish their own inherited IRA prior to distributing any of the inherited funds.
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Malcolm Ethridge, CFP®, CRPC® is an Executive Vice President and fiduciary Financial Advisor with CIC Wealth, based in the Washington, DC area. For more information or to schedule a consultation with Malcolm, click here.
Malcolm’s areas of expertise include retirement planning, executive benefits, investment portfolio development, and insurance. To subscribe to Malcolm’s monthly newsletter and receive more content like this, click here.
CIC Wealth, LLC does not provide legal or tax advice. Be sure to consult with your tax and legal advisors before taking any action that could have tax consequences.
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