Inherited IRAs: What You Need To Know | Podcast
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Inherited IRAs: What You Need To Know

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[Taking a distribution] is a tactical decision that needs to be made on a yearly basis. Context matters.

Andrew Busa, CFP®

Manager of Financial Planning

IRAs are one of the best tools we have for both saving for your retirement and passing wealth on to your heirs. But maximizing the value of an inherited IRA—and avoiding the snares of the IRS—requires some know-how. Rules have changed in recent years, and Cathy Lee and Andrew Busa are here to help guide you through what you (or your heirs) need to know to make the most of an inherited IRA. Topics include:

  • How the new “10-year rule” works and who it applies to
  • Why revising your estate’s trust documents is absolutely essential if you’re passing on an IRA
  • How to plan your tax strategy if you’ll be inheriting an IRA

Failing to understand and apply the new rules around IRAs could halve what gets passed on to your heirs. Don’t make that mistake! Listen now and let Cathy and Andrew help guide your strategy.

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Episode Transcript

Andrew Busa:

Rules around inherited IRAs may seem confusing, but they don’t have to be. Listen to this episode as we help you navigate the red tape.

Hi, this is Andrew Busa, manager of financial planning at Adviser Investments, and we’re here with another The Adviser You Can Talk To Podcast. Today I’m joined by my colleague Cathy Lee. She is a tax associate on the wealth management team here at Adviser.

Cathy, welcome.

Cathy Lee:

Hey, Andrew. Good to be here.

Andrew Busa:

Cathy has lots of financial planning and tax experience. She has her CFP®, she works very closely with many of our tax clients here at the firm, so with her help, we should be able to help you make some sense of how to best handle inherited IRAs because a lot has changed in the last two years. So we’ll cover three large topics today. Number one: The basics of inherited IRAs, which turn out to be not so basic, but we’ll do our best. Number two: Getting your tax strategy right because that’s really the heart of all of this that we’re going to be covering today. And third, finally: Some common examples that will help you make sense of the different rules and possibilities that could happen depending on the context that you inherit an account in.

Now, before we get into part one, the basics, it’s important—I want to kick it over to you, Cathy—to lay some groundwork for why this is so important to understand.

Cathy Lee:

Yeah, we don’t want any of our clients to be caught unaware if your inherited IRA account should be emptied at the end of 10 years, because there’s a 50% penalty.

Andrew Busa:

Yes. One of the stiffest penalties in the code, so we want to avoid that if possible. With that, let’s get into part one, some definitions, some quick rules. Cathy, lead us off with some history here.

Cathy Lee:

The SECURE (Setting Every Community Up for Retirement Enhancement) Act made major changes by requiring that most beneficiaries must draw down their inherited IRA within 10 years after the IRA creator’s death—no more stretching out the payments over the beneficiary’s life expectancy. An exception is carved out for comparatively smaller groups of beneficiaries such as spouses and minor children.

Andrew Busa:

Right, so now you’ve got adult children, grandchildren, most other designated beneficiaries now being stuck with this 10-year rule that you just mentioned, so that means more taxes payable sooner. Those exceptions that you just mentioned, spouses and minors—let’s keep that in mind and put some vocabulary behind it. Those folks are known as eligible designated beneficiaries, or EDBs.

Cathy Lee:

This new 10-year rule that was created doesn’t apply to EDBs. If you’re an eligible designated beneficiary, it’s business as usual, as if the SECURE Act didn’t pass. The 10-year rule will apply if you’re a noneligible designated beneficiary, or NEDB.

Andrew Busa:

While we’re throwing out all these acronyms, let’s just talk about one more: A non-designated beneficiary. That’s basically saying that there was no designated beneficiary on the account at all. One common example of where we see this is if someone names their estate as the beneficiary of their IRA, which is basically always a no-no, right?

Cathy Lee:

Yes, that’s right. If that’s the case, the IRA needs to be emptied within five years, accelerating taxes even further, and we’ll get into how this could happen and why you want to avoid this.

Andrew Busa:

Another area we see this occur, and this is a key takeaway, is if you were planning on using a trust as the beneficiary of an IRA, and that trust was drawn up pre-SECURE Act—that needs to be looked at immediately. If it was drawn up incorrectly or if it’s no longer relevant with these new laws, that trust could be considered a non-designated beneficiary and the IRA would need to be emptied within five years, so that probably is something you want to avoid.

Cathy Lee:

More recently, the IRS took the 10-year rule nine steps further. According to their March 2022 interpretation, the tax man seems to say that if the original IRA owner died on or after they were required to begin taking RMDs, their 72nd birthday, certain beneficiaries must empty the account in 10 years and take RMDs in years one through nine.

Andrew Busa:

This came as a bit of a surprise from the IRS, this recent interpretation. Again, that’s if RMDs had already begun by the original owner that is deceased. A recap here too: The IRS could modify these proposed rules that Cathy just mentioned before the guidance is set in stone. For now we’re advising beneficiaries who fall into this category to be prepared to continue an RMD, but do keep an eye on the IRS finalizing this regulation likely later this year.

Now, we talked about a lot in this section. It’s a lot to digest. Let’s just leave this with a couple of key takeaways. If you inherited an IRA or you’re anticipating inheriting one, really answer two questions for yourself. The first: Understand which of the two main categories you fall into. Are you either an eligible designated beneficiary, which would be a spouse, minor child, something like that, or are you a noneligible designated beneficiary, which would be an adult child, a grandchild would be the common examples there? Then the second thing: Have RMDs already begun from that IRA? If so, they will likely need to be continued. If not, you’ve got 10 years to manage distributions in accordance with your tax bracket, which we’ll get into in a second. That’s going to be the planning piece that we’ll talk about.

Let’s get into part two, tax strategy. Now the ideal tax outcome is if you’re an eligible designated beneficiary and you’re able to distribute the IRA over your lifetime, and that allows you to spread out the tax pain as much as possible.

Cathy Lee:

But the scenario that requires more proactive tax planning is if you’re a noneligible designated beneficiary, where you have a full 10 years to decide how to empty the inherited IRA. This is where financial planning being married to tax planning is very important. Understand your current and future tax picture, income bonuses, etc. That’s going to form the basis of how we’re going to empty the account. You might be retiring soon or anticipating a major drop in income, maybe you’re in between jobs or your income drops for some other reason. Rarely would we recommend waiting the full 10 years to take any distributions.

Andrew Busa:

Right, so this is where really being in tune with your income on a year-to-year basis and looking forward is very important. Cathy, we talked about this. It’s almost similar to planning for a Roth conversion, where a lot of times it makes sense to convert with tax brackets in mind. For example, here you might not want to take so large a distribution in those 10 years that you get bumped into a much higher marginal tax bracket if you can avoid it. These are tactical decisions that need to be made on a yearly basis with the information that Cathy just mentioned. Let’s keep in mind, too, that context matters depending on the balance of the account. From a tax-planning standpoint, a $50,000 IRA is very different to plan for compared to a $5 million IRA. The numbers are just so much larger when you’re dealing with those distributions and keeping in mind that those distributions count as ordinary income.

Cathy Lee:

Age is a consideration too. If you’re close to Medicare age, these distributions could dramatically affect your Medicare premiums if you’re 63 or older while taking distributions. This could also affect the taxation of your social security. When you speak with your financial adviser about this, keep these topics in mind.

Andrew Busa:

Yeah, those are really good points, and those are the nuances that need to be paid attention to when you’re thinking about distributions. It’s all a bit of a tax minefield to navigate, and we don’t have time to cover all of the finer details in one episode, but like Cathy said, work with your adviser, your tax preparer, to make sure that you’re getting the right advice for you.

I think that’s a really good overview of general tax strategy. Let’s spend some time talking through a little bit of a lightning round, some common examples where you might be able to make some sense, you might see yourself in one of these examples and be able to understand how these new inherited IRA rules might apply to you. Cathy, I’m going to hit you with some examples here, all right? First one: IRA owner dies at 67, RMDs have not begun, and a child of 40 inherits it.

Cathy Lee:

This is the 10-year rule. Manage your tax brackets accordingly. The child is a non-EDB, starts the following year, and the account needs to be emptied by the end of year 10. Tax strategy for this? Consider your income and future income picture, filing status, all this plays into it.

Andrew Busa:

Great, so this is that one where you’ve got some flexibility over the 10 years because RMDs have not begun. Now pulling on that thread a little bit, how about if the original owner dies at 75 and RMDs had already begun and a child of 40 inherits it?

Cathy Lee:

10-year rule still applies. This is now the 10-year rule with RMDs. RMDs need to continue based on a single life expectancy of the beneficiary. The account must still be emptied by year 10. Keep in mind, you could take more than the minimum if you find yourself in the middle of a lower income year than usual.

Andrew Busa:

Right, so this relates back to that new IRS guidance that we mentioned in the first part that came out recently, so continuing those RMDs in years one through nine, but that’s a good one. All right, how about one that’s a little different here? This is an IRA owner who is 55 and leaves it to his 53-year-old sister and 57-year-old brother.

Cathy Lee:

In this case, the 10-year rule doesn’t apply. Not more than 10 years younger, they are considered eligible designated beneficiaries, business as usual.

Andrew Busa:

This is actually one that we didn’t mention off the top in the first part, this category of people who are not more than 10 years younger. I love the government language behind some of this stuff. Sometimes they make it more confusing than it has to be, but this is one of those kind of odd exceptions where the 10-year rule, like you said, would not apply, it says, as if the SECURE Act never passed.

Here’s another common one. We see this a lot with clients, and this is between spouses. What if a husband dies at 75 and leaves the IRA to their spouse? What happens in that case?

Cathy Lee:

The spouse has options. They can treat it as their own, and generally this is the most commonly advised method. There’s the 10-year method and the life expectancy method.

Andrew Busa:

Yeah, so this one does pop up commonly, so if you have questions, let us know, let your adviser know, we’re happy to help.

We’ve covered a lot of ground and in a short period of time here, and I know this is a very information-dense topic with a lot of rules, but hopefully you found this a little simpler than you made it out to be before you started listening. But Cathy, any key takeaways before we leave the listeners on this topic?

Cathy Lee:

I think if you’ve been diligently saving in your IRA and it’s grown significantly, you should reach out to your financial adviser for planning due to these changes.

Andrew Busa:

Yep, that’s a good one. I’d highlight a couple of ones that we talked about through the episode. Again, if you have a trust that was created before the SECURE Act, and it hasn’t been updated since then, and it’s scheduled to be the beneficiary of your IRA, you’re going to want to take a look at that to make sure that your estate plan is set up correctly. I’ll leave the listeners with that one.

 

This has been Andrew Busa and Cathy Lee from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show, and you can also check us out at www.adviserinvestments.com/podcasts. Your feedback is always welcome. And if you have any questions or topics that you’d like us to explore, please email us at info@adviserinvestments.com.

 

Thanks for listening.

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