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Avoiding Mistakes When You Inherit an IRA

Careful decision making by the IRA owner and the beneficiaries is necessary so heirs don't pay more taxes than necessary. Adviser Doug Gjerde explains the various factors.

By Doug Gjerde, CFP

I have witnessed costly mistakes people made when they inherited IRAs. The rules around inherited retirement accounts have become even more complex since the SECURE Act passed in 2019. Most of the mistakes were made because the decision seemed simple, but the grieving survivor didn’t understand all the consequences or all the choices they actually had.

Doug Gjerde, MBA, CFP® is Managing Partner, Wealth Advisor of Heritage Financial Partners, and is a member of Ed Slott’s Elite IRA Advisor Group.

Doug Gjerde, CFP

These slip-ups have included:

· the surviving spouse being forced to pay penalties that could have avoided,

· large penalties on missed required distributions (the penalty is 50% of the amount missed) and

· heirs paying significantly more in taxes on the inherited account than they might have.

I implore our clients that if they receive an inheritance, “don’t do anything until talking to us.” Losing a loved one, especially a spouse, can be a crushing experience. When you are grieving, making good financial decisions while adjusting to your changed life can be quite difficult.

In some instances, heirs pay substantially more in taxes than necessary because the IRA owner does not have a contingent beneficiary listed on their IRA. Make sure the beneficiaries are updated on your IRA and that you list contingents in addition to primary beneficiaries.

If you inherit an IRA (or 401(k) or other tax-deferred account) you’ll have to make a decision on how you want to treat it and receive it. You will always have some choices. Most of these choices are irrevocable. You won’t get a do-over.

Take Your Time

How to receive the IRA may seem like a minor decision with all you are faced with after your loved one dies. It may be minor, but it also may have expensive consequences. If you don’t talk to a professional, which is my suggestion, please make sure you are educated so you don’t make an expensive rash decision. You do not have to make a quick decision. Take your time.

Factors that impact your choice:

· Are you younger than or older than 59 ½ years?

o If you are younger than 59 ½ are you likely to need or want to distribute money from this account before you turn 59 ½?

· The larger your estate the more costly a mistake will be. How large is large enough varies by your state of residence and your situation. In general, if your estate is a few million or more spend some time or money to make sure you don’t make a mistake.

· If inheriting from your spouse, are you younger?

· Was the person you are inheriting from already taking their required minimum distributions (RMDs) from the accounts?

All of these factors can have an impact on which of your choices ends up benefiting you, and possibly your heirs, the most.

Frequently you have as many as five different methods you can choose from. They are:

1. Inherit the account as a beneficiary account

If you are a spouse and you need money from the account before you turn 59 ½ you may want to remain a beneficiary of the inherited account. By remaining as a beneficiary, you avoid the 10% penalty for early distributions. The account will need to be retitled as a properly titled inherited account to take advantage of this special rule. Once you turn 59 ½ you’ll likely want to then take the steps described in number 3 below.

2. Take a lump-sum distribution

You may take all the money in the account as a withdrawal and avoid the 10% early withdrawal penalty. If it is a small IRA this may make some sense. However, you’ll owe taxes on the withdrawal with this option and withdrawing the entire balance may move you into a higher tax bracket. If you are still working you may pay more in taxes by taking the distribution now than if you deferred the withdrawal, and therefore the taxes, by keeping it in a beneficiary IRA until later when you will be in a better tax position (such as in retirement).

3. Roll the inherited account into your account

Only spouses have this option for IRAs. Generally, a spouse beneficiary should roll the inherited IRA into their own name. Once a spouse turns 59 ½ there’s no advantage to remaining a beneficiary and a spousal rollover should be done. There is no deadline for this.

By doing this rollover, a surviving spouse ensures that eligible designated beneficiaries will be able to stretch distributions over their own life expectancies. The longer the heirs can stretch the IRA, the less taxes they may owe on it and more time the account can grow tax deferred.

4. Split the inherited account

There are special spousal rules that benefit a spouse who inherits an IRA. If the spouse isn’t the sole beneficiary, all is not lost. The spouse can still take advantage of the special provisions by transferring their portion of the inherited IRA to a separate account (all their own). To take advantage of the special provisions this must be completed by December 31st of the year following the IRA owner’s death.

5. Disclaim the account

If you have a large estate and the possibility of estate taxes might loom in the future there are some ways to avoid or diminish this. By using a disclaimer, some or all of the inherited IRA can be passed to contingent beneficiaries, potentially extending the stretch IRA and reducing the future impact of estate taxes for eligible designated beneficiaries.

If you inherit an account, consider meeting with a professional to ensure you understand your choices and can implement a tax-efficient strategy. Take your time and make the right choice. Given the complexity of the new rules and the potential for wrong decisions to be costly it’s a good idea to meet with an estate or financial planning professional to make sure your accounts are setup to carry out your wishes and minimize taxes at your death.

About the author: Doug Gjerde, CFP®

Doug Gjerde, MBA, CFP® is Managing Partner, Wealth Advisor of Heritage Financial Partners, and is a member of Ed Slott’s Elite IRA Advisor Group.

Investment advisory services offered through CWM, LLC, an SEC Registered Investment Advisor.

This piece is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.

Distributions from traditional IRA's and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 1/2, may be subject to an additional 10% IRS penalty.