Leave a Lasting Legacy to Your Loved Ones with an Inherited IRA

Estimated reading time: 7 minutes

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.


Compound Interest: How It Works In Building Wealth

Estimated reading time: 5 minutes

Compound interest is a fundamental concept in personal finance that can be utilized to generate long-term wealth through the ability to let your money work for you. Compound interest allows for exponential growth of investments, hence the phrase “the power of compound interest.” The more frequently the interest is compounded, the faster the investment will grow. This is because with more frequent compounding, there will be more added interest to the principal amount, which leads to more interest being earned on that interest. As a result, the investment grows faster over time helping you reach your financial goals.

Understanding How Compound Interest Works

It is important to first understand the difference between simple and compound interest. Simple interest is calculated only on the principal amount, whereas compound interest is calculated on both the principal and the interest earned. One of the key differences between compound interest and simple interest is the time period. Simple interest is usually calculated based on a fixed period, regardless of the amount of time the money has been invested. In contrast, compound interest is based on the amount of time the money is invested. The longer the investment period, the higher the returns from compound interest.

Compound interest is an essential concept for investors to grasp as it allows for exponential growth of investments over time. Understanding how compound interest works can help in making informed investment choices. To start becoming familiar with how compound interest works, one must first understand the variables in the compound interest formula. This formula involves four main variables: the starting principal amount, the interest rate, the frequency of compounding, and the duration of the investment. It’s important to understand how each of these variables affects the overall outcome of an investment. By doing so, they can gain the maximum advantage from compound interest and achieve their financial goals.

The principal amount refers to the initial sum of money invested. The interest rate is a percentage of the principal amount that is added to the investment each year. The frequency of compounding refers to how often the interest is added to the investment, which can be daily, monthly, quarterly, or annually. The more frequent the compounding, the faster the investment will grow resulting in higher returns. For instance, an investment with monthly compounding will yield faster growth than an investment with quarterly compounding.

Starting with a larger principal can have many benefits when it comes to building wealth with compound interest. A larger principal means that the potential earnings will be higher, resulting in greater wealth accumulation over time. For instance, if two individuals invest in the same investment vehicle, but one starts with a higher principal, they will earn more interest than the individual with a smaller starting principal. Additionally, a larger principal can help individuals reach their short-term financial goals faster, as they have more money available for investment.

Lastly, the duration refers to the time frame for which the investment will grow. Investments need time to compound in order for the returns to grow. For example, consider a self-directed IRA account with an investment that has an interest rate of 5%. If an individual opens the account with a $10,000 initial investment and leaves it untouched for 10 years, they will earn approximately $6,386 in compound interest on that investment. However, if they hold that investment in the account for 20 years, they will earn approximately $16,386 in compound interest. Add the fact that these investments are being conducting inside of a retirement account, those profits are also growing either tax-deferred or potentially tax-free. This illustrates how the duration of an investment can greatly impact the power of compound interest and help you achieve your long-term financial goals.

How It’s Calculated

The most important aspect of understanding compound interest is the compound interest formula. Each component of the formula plays an important role in calculating the future value of investments. To calculate how much compound interest you would receive over time, you can use this compound interest calculator from investor.gov. This is a great tool to help you with your financial planning.

Creating Generational Wealth with Compound Interest

While compound growth can benefit anyone who starts early and holds quality investments for a long period of time, it can also be used to create generational wealth that can benefit not just the current investor, but also their children and grandchildren. Using the concept of compound interest to create generational wealth is a smart strategy that can help individuals and families build long-term wealth that can benefit future generations by being passed down.

For example, if you start with $10,000 and add a $300 monthly deposit, you’ll have contributed $82,000 in 20 years, but with an estimated 5% interest rate compounded annually, your money will have grown to over $145,500. If you increase your contribution to $500 per month with the same interest rate and the same duration, your investment will now be worth $241,197! Small changes in contributions, interest rates and duration can make a huge impact on the long-term growth of your investments and the ability to reach your savings goals.

One way to take advantage of compound growth is through tax-advantaged retirement accounts, such as self-directed IRAs, Health Savings Accounts (HSA), Coverdell Education Savings Accounts (ESA) and 401(k)s. These accounts allow investors to contribute pre-tax dollars, which can reduce their taxable income and potentially save them thousands of dollars in taxes over the course of their career. In addition, gains in these accounts are tax-deferred until they are withdrawn, which can further boost investment returns. Some accounts, like the Roth IRA, even grow profits tax-free!

To maximize investment returns and create generational wealth, investors should diversify their investments across a range of asset classes, private and public, and custodians like Quest offer alternative investment solutions. By starting early, investing in quality companies, taking advantage of tax-advantaged retirement accounts and employer-provided plans, diversifying investments, and utilizing dollar-cost averaging, investors can maximize returns and create a legacy of wealth for their loved ones.

Understanding how compound interest works is extremely important when devising a financial plan to work toward financial freedom. Small differences in interest rates, compounding frequency, and investment duration can have a big impact on the final value of an investment. By understanding the compound interest formula and how it’s calculated, individuals can make informed decisions and maximize the power of compound interest. When investing, careful consideration should be taken, but if you ever have questions about self-directed IRAs or setting up a retirement plan, reach out to an IRA Specialist and schedule a 1 on 1 consultation today.


Using Your Self-Directed IRA to Meet Your Estate Planning Goals

Estimated reading time: 2 minutes

Using Your Self-Directed IRA to Meet Your Estate Planning GoalsYou probably already know how valuable a self-directed IRA can be to help you meet your long-term retirement goals. With its wide range of investment options, an IRA with a self-directed custodian such as Quest Trust Company can let you execute a wide range of investment strategies.

But are you aware that you can also use a self-directed IRA to help you meet your estate planning goals? And did you know that a Roth self-directed IRA has certain advantages in this regard compared to a traditional self-directed IRA? Let’s take a closer look at how you can use a Roth self-directed IRA to meet your unique estate planning goals.

The primary way of using a self-directed IRA to accomplish estate planning goals is through the use of account beneficiaries. As with your other investments and assets, you can name primary and contingent beneficiaries of your self-directed IRA, and do so either with respect to individual assets within your account, or as a percentage of account value.

This can be a great way to make sure that specific individuals receive specific assets in the event of your passing. For example, if you hold real estate in your self-directed IRA (which you wouldn’t be able to do in an IRA held with a custodian such as a discount broker or your local bank), you can name a particular family member or other beneficiary that you want to receive that asset in the event of your passing.

And if you choose for your spouse to be your account beneficiary, they’ll have certain tax advantages in how they can choose to receive your account, and in this way you can lessen the tax burden of your passing.

A Roth self-directed IRA is not subject to the rules on required minimum distributions. These rules, which apply to traditional self-directed IRAs, dictate that once you reach age 72, you must begin taking minimum distributions from your account every year. The principle behind these rules is to balance the tax-deferred growth of a traditional self-directed IRA with the need of the federal government to eventually be able to receive the taxes they’re owed.