“Suppose you were an idiot, and suppose you were a member of Congress; but I repeat myself.”
–Mark Twain
“You only give a traditional IRA to heirs you don’t like after this (Congressional) rule change. You give them a traditional IRA, and the IRS is pounding them over the head with a sledgehammer every year.”
–Clark Howard
HALLOWEEN AND THE INHERITED IRA “TAX BOMB”
It is Halloween, and a time for scary stories.
Here is one: if you inherit a Traditional IRA or 401k, Congress has done its best to make sure you cannot use it directly for your own retirement. Instead, they turned it into a “tax bomb” that pushes you into higher tax brackets as much as possible.
You see, when you inherit a traditional IRA, you are required to be paid from the traditional IRA over only 10 years, not a lifetime. That extra income can push you into higher tax and/or Medicare brackets. Those extra taxes can severely reduce the buying power of what you have inherited.
YES, I INHERITED A TRADITIONAL IRA
An inherited IRA is complicated. And after the death of a loved one, it is often an unwelcome complication that cops up during the mountains of complex paperwork that occurs while you are trying to settle an estate.
I tried to deal with it as soon as possible. But at the time, there was a lot of contradictory information, including from agencies that regulate and enforce policy.
In fact, as more confusing and contradictory information came forth, I began to feel unmoored. It felt as if my thoughts on this subject had become free-range chickens, roaming about at random. So I took the most conservative approach. After all, I was extremely fortunate to have an inheritance, even if it was highly taxed.
A year later, I decided to write this post in the hope that it might guide others facing the same situation. Fortunately, some of the regulations have been clarified in the interim.
AN INHERITED TRADITIONAL IRA AND THE BAD NEWS ABOUT TAXES AND RETIREMENT
Before moving on, a little history is helpful. The law didn’t used to be this way. At one point, you could stretch out an inherited IRA’s payments over your lifetime. That option is not available now.
Because funding retirement is much harder than when the legislation was enacted, many of the existing rules have not aged well.
The SECURE Act ended the ability to take lifetime withdrawals. To summarize, the SECURE Act (“Setting Every Community Up for Retirement Enhancement”) introduced changes to retirement account rules a few years ago. They included the following revisions to the tax code:
• Raising the age for Required Minimum Distributions (RMDs) from 70½ to 72 (later increased to 73 by SECURE 2.0), and allowing traditional IRA contributions at any age if you have earned income
• Requiring most non-spouse beneficiaries of inherited IRAs to empty the IRA account within 10 years instead of stretching distributions over life expectancy. There are a few exceptions but not many.
• Requiring that your heirs will also have only 10 years to empty their inherited IRA accounts if they inherit from you.
THE CURRENT RETIREMENT CRISIS AND INHERITED IRAs
Given the terrible state of retirement in the US, you must ask yourself why Congress enacted legislation that doesn’t help people retire.
First, many people are not prepared for retirement at all. Most to HALF of new retirees have little or NO savings. An inherited IRA used to be a lifeline for an heir unprepared for their own retirement. The inheritor could take payments for the rest of their life. No longer.
Second, we are all living longer, which increases total retirement costs for most of us. For men, the average life expectancy at birth has risen to 76.5 years. For women, it is 81.4 years. We need as much flexibility and as many options as possible if we reach an advanced age.
Third, care costs have increased. In the last years of life, care has become incredibly expensive to fund. One of my favorite authors began to explore the actual cost of keeping his parents safe in their old age. The cost is staggering and far exceeds what most people have saved.
Finally, the cost of retirement, like everything else, has gone up due to inflation.
RETIREMENT CAN BE A LONG COMMITMENT FOR THOSE LUCKY ENOUGH TO INHERIT, BUT INHERITED TRADITIONAL IRAS ONLY GIVE 10 YEARS TO HELP FUND IT
What kind of circumstances are inheritors likely to face?
Most people inherit between ages 50 and 65.
For many, the 10-year rule makes little sense and doesn’t reflect retirement realities. Inheritors often have 20-30 more years to live, not 10.
It reminds me of a diet where you have to eat twice as much as usual for the first 6 months and then starve the rest of the time.
INHERITED IRAs: A FEW UGLY FACTS AND OBSTACLES
Here are a few things you should know about inheriting a traditional IRA or 401k:
- The main point, repeated: the inheritance is taxed like additional salary income.
- There are few ways to shelter the income you receive. If you invest in a real estate venture, loan interest and depreciation costs might help. A charitable donation can help too. But the options are limited. You can expect much more tax if you inherit a traditional IRA.
- A direct Roth conversion or traditional IRA conversion using the funds from an inherited IRA is prohibited. That prevents direct tax savings toward retirement.
- There is a minimum annual withdrawal. The Federal government still requires that from an inherited IRA (See here). You don’t have the option to skip a year or avoid it altogether.
The year I inherited, there was an especially substantial payment due the first year, almost 20 percent of the whole account. The amount was equal to my mom’s Required Minimum Distribution if she had lived, an astronomical amount at her age of 95. That was a shock.
THE BIGGEST FINANCIAL TRIPWIRES: AVOIDING EXTRA TAXES AND COSTS
Any payout from an inherited IRA can increase your costs. That is why many people work with a fiduciary financial advisor to make sure the amount they withdraw doesn’t cost them unnecessary tax or additional Medicare payments.
The most costly obstacle is that the additional income may push you into a higher tax bracket. The tax brackets are here. Your state taxes and their tax brackets are another consideration. They will vary depending upon which state you live in.
If you are on Medicare, your rates are tied to how much money you make. The thresholds (see here) are different than your taxes. Their calculation also isn’t like tax law and includes exceptions and additions. Even a single dollar over a limit can trigger Medicare payments that can cost hundreds of dollars more each month.
OTHER LEGAL TRIPWIRES: THE 5-YEAR RULES FOR ROTH IRA CONVERSIONS
Confused by all the obstacles? You are not alone. For instance, you still need to know about a few other rules.
There are two different “5-year rules” that apply to Roth IRAs and their conversions, and they are often confused.
- The Roth IRA earnings 5-year rule (applies to everyone). This rule determines whether you can withdraw investment earnings tax-free. The 5-year clock starts on January 1 of the year you first fund any Roth IRA (either by contribution or conversion). Once you’ve satisfied the 5-year requirement and you’re age 59½ or older (or another qualifying event applies), you can withdraw all earnings tax-free.
- The Roth conversion 5-year rule (applies to each conversion). Each Roth conversion has its own separate 5-year clock. It prevents people under age 59½ from converting money and immediately withdrawing it without paying the 10% early withdrawal penalty. Every conversion starts a new 5-year period beginning on January 1 of the conversion year.
Put another way, most of us must wait 5 years before withdrawing from a converted IRA. I have seen mixed results on whether this applies to those over age 59½.
All of this complexity is another way of saying for most readers: get professional help as you craft a strategy to best deal with an inherited IRA, especially if it is sizeable. Popular guides exist, but they do not replace professional advice from a fiduciary.
IS THERE A HAPPY ENDING?
You may be wondering about ways you can blunt the impact of this legislation. Remedies are limited, and we’ll cover them in the next post. Decisions about an inherited IRA are not always what they seem, and that is key to making the right choice.
DISCLOSURE
Disclaimer: Consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
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Photo Credit: Sabina Music Rich