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I am the Beneficiary of a large IRA, now what?

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Introduction

Inheriting a large IRA can be a life-changing experience. It can provide you with the financial security you need to reach your goals, such as paying off debt, saving for retirement, or investing for the future. However, it’s important to make good decisions about how to manage the money. If you’re not careful, you could end up blowing the inheritance or making costly mistakes.

In this article, we’ll discuss the basics of inheriting an IRA, including the different types of beneficiaries, the tax implications, and some tips for avoiding common mistakes.

Before we get into some of the financial challenges of receiving an IRA as a beneficiary, let’s take a look at some of the bigger-picture planning concerns that you will want to consider before you receive the funds.

Three steps to take when receiving an inheritance

First, statistics show that about one in three blow their inheritance and do so quickly.  Further, a study by the Williams Group Wealth Consultancy found that 70% of well-to-do families lose their wealth by the second generation and 90% by the third generation.  It’s a responsibility to receive an inheritance and many are simply ill-equipped to make good decisions.  Here are a few pointers to help increase your odds that you won’t lose your newfound wealth:

  1. Hire an advisor.  Not just a money manager, but an advisor who is equipped to help you develop a financial and tax plan for how to manage this event.  Money management comes later in the process.  We recommend hiring a fee-only fiduciary planning firm that is required by law to act in your best interests.  Try to get your advisor and CPA communicating with one another as your financial decisions usually impact your tax return.
  2. Don’t make any financial decisions for a while.  Use your time to let the dust settle, examine your priorities, and create a plan for moving forward.  Then you can move on to implementing the plan thoughtfully and with purpose.
  3. Keep information close to the vest.  People tend to come out of the woodwork when they hear of inheritance events.

INFOGRAPHIC: 70% of well-to-do families lose their wealth by the second generation and 90% by the third generation

The different types of IRA beneficiaries 

Spouses named as IRA beneficiaries have it the easiest.  They are referred to as eligible designated beneficiaries.  They can roll over their spouses IRA account into their own IRA or open a new IRA account.  No taxes are due immediately and the funds can remain in their tax deferred status.  If the spouse is under age 59 ½ he/she is subject to the 10% penalty plus taxes for an early withdrawal.  After age 59 ½ you can access the funds and pay tax as if it were ordinary income. The IRS requires that required minimum distributions be paid from the IRA account beginning at age 73.  The Uniform Table is used to determine the required minimum.  If the spouse was named as the beneficiary of a Roth IRA, no required minimum distributions are required.  RMD’s are only required from Roth IRA accounts after the spouse dies.

In addition to the surviving spouse, other eligible designated beneficiaries are minor children, disabled or chronically ill people, or those who are not more than 10 years younger than the IRA owner.  Eligible designated beneficiaries can keep the money tax sheltered but must take required minimum distributions based on their life expectancy with the exception of minor children who when they turn 18 must empty the IRA account using the ten-year rule.

The second type of beneficiary are non-eligible designated beneficiaries. These individuals are required to empty the IRA account they receive by December 31st in the tenth year following the original IRA owners death.  There are no required minimum distributions required during the ten years.  You can decide when to remove the funds from the IRA, but, as they come out, they are taxed at the beneficiaries tax rate.  There is no 10% penalty if under age 59 ½ as distributions are being made over the ten-year period.  Roth IRA accounts must be emptied using the same ten-year requirement except there is no tax due on the withdrawals.

The last type of beneficiary is a non-designated beneficiary.  These are non-person entities such as a charity, estate, or trust.  Funds must be removed within five years of death for this group.

Tips for avoiding common mistakes 

There are a couple of other things to remember for large IRA’s.  If beneficiaries had to use IRA funds to pay estate tax, they can take a tax deduction on the amount paid.  But this is rare now that the federal estate tax exemption is over 12M per person!  Beneficiaries of IRA’s can also donate up to 100K to charity yearly.  This is called a qualified charitable distribution and is NOT a taxable event.  QCD’s are a valuable tax planning tool now that the threshold for filing using itemized deductions has been lowered.

When you receive a large IRA account, one of the mistakes people make is not considering the shrinkage of the IRA due to taxes, especially if the beneficiary is in a high tax bracket themselves. So, clearly, one will want to time distributions so they experience the least amount of tax shrinkage as possible.  For example, after retirement and before social security and required minimum distributions start can be a great time.

Being the beneficiary of a large IRA can be a life changing experience.  But, be careful!


You can read more about taking distributions from Individual Retirement Arrangements (IRAs) at the IRS, here.

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