Dealing with death is never easy, but most people would agree that when we go, we want to leave a financial legacy behind for our loved ones and make the transition of assets as smooth as possible. There are multiple ways to leave a legacy from a life insurance policy to a living will or trust to just leaving assets or cash to your next of kin. But one of the most important ways to leave a real legacy to your family, and arguably the best way, is through an inherited individual retirement account (IRA).
What is an Inherited IRA?
An inherited IRA is basically the account you set up when you inherit a tax-advantaged retirement plan, such as an IRA or 401k. The assets from the original account holder are transferred into a newly opened IRA in the beneficiary’s name, which is why it is also known as a beneficiary IRA.
What are the Benefits of an Inherited IRA?
Many people do not realize that when you pass away, most of your assets, cash, and material possessions will be taxed before being given to your heirs. The IRS calls the death tax, and these estate taxes can range from 18% to 40% in total. Just imagine someone close to you died and left several thousand dollars to you in a checking account, and before you even take possession of those funds, the IRS takes up to 40% of it in taxes. Seems a little unfair don’t you think?
Now let’s take the same example described above, but instead your loved one left the same funds to you inside of their retirement account. Upon their death the money would be transferred to you into an inherited IRA with no additional taxes applied at that time, literally escaping 100% of the death tax. Which of those two scenarios sounds better to you?
While avoiding the Death Tax is a huge benefit, another possibly even bigger advantage of inherited IRAs comes from the investing side. This is the ability to compound the growth of those funds without having tax consequences today. For example, every investment that has earnings attached to it will always be taxable. If we made $100K on an investment, we could potentially lose 20% or more to taxation, and walk away with only $80K. However, if we did this same investment utilizing an inherited IRA, we would be able to keep the entire $100k today, giving us a chance to fully compound these funds at an exponential rate.
How Does an IRA Pass to Your Beneficiary?
Inherited IRAs typically fall into two categories: you are either the spouse of the person who passed away or a non-spouse beneficiary. If you inherit an IRA from your deceased spouse, you generally have the following three choices, but only the first one is available to spouses exclusively.
- As the spouse, you can take the account as your own. When doing so, you are labeling this as your own IRA and not any form of inheritance. This means you can still make normal contributions to the account and follow the same IRA rules. These include being 59½ before taking penalty free distributions and Required Minimum Distributions (RMD) will still be required from tax deferred accounts starting at age 73 (this updated as of January 2023). This is a common option for a spouse when they inherit an IRA over the age of 59.
Both spouses and non-spouse beneficiaries can select from the following options:
- You can take the IRA as an inherited IRA. In doing so, you can no longer contribute to this IRA, but you can invest into anything you see fit or feel comfortable with as long as it is not through a disqualified act. The account can still grow tax deferred (or post tax if it is a Roth IRA) but because of the 10-year rule, must be fully distributed to the account holder within a 10-year period which begins the year after the original account owner’s death. This is very common among younger spouses because they can spend the funds today penalty free (and tax free if it is a Roth IRA).
- The person inheriting the account also has the option to disclaim it. By disclaiming, you are stating that you do not want this IRA, and it will go to the next of kin that is listed on the beneficiary form. This is important because the person who disclaims it does not get to choose who it goes to, or whether it goes to whoever is labeled as the contingent beneficiary on the IRA. If no one is listed, then it will go to the estate of the deceased. This option is not commonly used since most people would rather claim it as their own IRA or claim it as their own inheritance and still be able to invest the funds in it.
How Did the Secure Act Change Inherited IRAs?
The rules regarding inherited IRAs have changed in recent years with the passage of the Secure Act which went into effect in 2020. To understand what we lost, we need to first lay a foundation of how inherited IRAs used to work. Pre-December 2019, you could inherit an IRA from someone, and that IRA would survive for your life expectancy. It could grow either tax deferred or tax free for decades. The way this was calculated can be seen on IRS publication 590-B under Life Expectancy. The year you inherited the account, the IRS would then give you a life expectancy. From there, the newly inherited IRA would last for that said life expectancy and have a RMD every year moving forward. As an example, if I was 35 years old, the IRS would give me a Life Expectancy of 51 more years. I could then grow this inherited IRA completely tax free for 51 more years.
Unfortunately, many people would take advantage of this rule, sometimes even leaving these accounts to one-year-olds hoping that the account could grow tax free for longer periods at a time. Due to these actions, a clause was put into the Secure Act in 2020, and the rules have been forever changed for inherited IRAs.
Now the IRS will not allow you to compound these investments permanently. With the Secure Act, you have 10 years to grow these inherited IRAs without any tax consequences. At the end of the 10-year period, you will need to take a full distribution of those retirement funds. If you inherited a traditional IRA (or any other tax deferred retirement account), then you will be taxed at your current tax bracket on any funds that were distributed. However, if you inherited a Roth IRA, then that distribution would be 100% tax free. Imagine for a moment that you were able to leave behind to your spouse, children, and grandchildren, a vehicle that they can use to invest in just about anything, while fully avoiding taxation from the IRS. That is how you truly leave a legacy.
Even with the changes made by the Secure Act, these are still some of the most powerful investment accounts to be self-directed. The real way to grow wealth is using a self-directed inherited IRA to invest into privately held companies, real estate, oil and gas, and much more, and still be able to avoid taxation on these investments.
How to Set Up an Inherited IRA?
We get this question a lot, but this is not an account you just set up, it is one that is inherited. This means you will be setting up your own self-directed IRA. You must list who will be the beneficiaries to this IRA, and they will be the ones to receive your legacy building account. It is important to mention that your retirement account will always supersede a will or a trust, so keep those primary and contingent beneficiaries up to date with your IRA custodian.
Inherited IRAs are one of the best ways to avoid taxes, build wealth for generations to come, and leave behind a true legacy. It’s important to take the time for estate planning to create a legacy for you and your family. Set up a self-directed IRA, maximize your contributions, and make sure that your family understands what to do when you pass. If you are interested in setting up a self-directed IRA, or have more questions about the process, you can set up a 1 on 1 with a Quest Trust Company IRA Specialist. By utilizing these accounts appropriately and educating your family on the process, you can change your family’s lives forever and build wealth for generations to come.