You’ve likely seen something in the news about the SECURE Act, which was signed into law at the end of December. It is a retirement reform bill, so you probably think it doesn’t really matter to you right now.
But you’re wrong.
There are provisions in the SECURE Act that could have major effects on your finances long before you start thinking of retiring.
What Is An Inherited IRA?
What are the chances that your parents or grandparents are going to pass away before they’ve spent all of their retirement savings and they’ll leave it to you? If there’s any chance that you could ever inherit an IRA during your lifetime, you need to keep reading.
When someone passes away and they still have money in an IRA, the account is transferred to whoever is listed as their beneficiary. It is not a part of the will or estate unless they have no beneficiaries listed. If the account passes to a spouse, then all that changes is the name on the account. If it goes to a non-spouse, then it becomes an inherited IRA and is subject to different rules.
Inherited IRA Law Prior To 2020
Previously, inherited IRAs were subject to required minimum distributions (RMDs). These are amounts that an account holder is required to withdraw from the account by law or face a 50% penalty from the IRS. RMDs were calculated so that the account would gradually be emptied over the lifetime of the heir.
For example, let’s say you are 30 years old and you inherit a $200,000 IRA account from your father. If your life expectancy is 50 years (you’re expected to live until age 80), then you would divide the account balance by your life expectancy to find your RMD. That first year, you would be required to take $4,000 out of the account. RMDs are calculated each year based on numbers provided by the IRS, but that is basically how they work.
Under the old law, the heir of an IRA account was able to gradually empty the account so that it didn’t have a major impact on their financial situation or tax liability. Also, it was popular to name young family members as beneficiaries so that the money could stay invested as long as possible in the tax-advantaged account.
How The SECURE Act Affects Inherited IRAs
The SECURE Act that went into effect on January 1, 2020, changed everything for inherited IRAs. There are no more required minimum distributions and accounts must be emptied within 10 years of the original account owner’s death.
These new rules do not apply to spouses or disabled people. They do not apply to the minor children of the original account owner until the child reaches the age of majority. For everyone else, this is the new law.
What does it actually mean, though?
Going back to our earlier example, how would inheriting that $200,000 IRA look under the new law? You could spread out the withdrawals evenly as if RMDs applied and have $20,000 of additional income plus growth for ten years. Or you could wait 10 years and withdraw the entire $200,000 (which could have grown to $300,000 or more by then) at once.
Having no RMDs means that you can simply leave the money in the account and no one will be telling you to take any out. That can be good and bad. It’s nice to have the flexibility to leave the money in to grow if you don’t need it right away. But, if you leave it in the account, you could end up having to take all of it out in the same year, since it must be emptied within ten years.
How Inheriting An IRA Can Affect Your Finances
Emptying an entire IRA account in one year could wreak havoc on your finances. If the money is from a traditional IRA, it is taxed as regular income. That could push you into higher tax brackets during your highest-earning years and your tax bill could swell.
Let’s see how that looks with real numbers. Brian and Kristin earn $74,800 between the two of them and Kristin’s grandfather just died and left her a $200,000 IRA. For our calculations, we are going to assume that they continue to have the same income for the next 10 years, they take the standard deduction of $24,800 and it stays the same, and that tax rates do not change either. The IRA is invested so that it is growing at a rate of 8% per year.
If Brian and Kristin wait until the last minute and don’t take anything out of the IRA until 10 years has passed, the account would grow to a balance of about $400,000. That sounds wonderful until it comes time to file their tax return. On the IRA withdrawal alone, they would have to pay a total of $91,485 in federal income taxes and some of that money would come out at a 35% tax rate.
What if they didn’t wait until the last minute and instead spread their withdrawals out over the entire 10 years? They would have to take $27,600 out of the account every year in order to completely empty it by the end of the 10 years. Because that’s not a very large amount, it wouldn’t push them into a higher tax bracket so they would only ever pay 12% federal taxes on the withdrawals. Their tax bill related to the withdrawals would be $3,312 a year for a grand total of $33,120.
What’s the difference between the two courses of action? Almost $60,000 in taxes. By spacing out their withdrawals, Brian and Kristin only end up paying about ⅓ the taxes they would have if they took a lump sum at the end of 10 years. Of course, this scenario uses a lot of assumptions that could change over time, but it does give an example of how much less income tax could be paid by spreading withdrawals out over 10 years. It's also important that the couple invest the proceeds each year as they withdraw it. Ideally, they'd take the $27,600 each year and use it to max out accounts that grow tax free like 401(k)s, 403(b)s, Roth IRAs, HSAs, etc.
On top of the tax savings, there are a lot of other things tied to your taxable income. Having too high of an income can make you ineligible for the child tax credit, Roth IRA contributions, and other tax deductions and credits. If you have a child heading off to college, that high-income year could skew the numbers on their FAFSA, reducing their financial aid eligibility. If you’re receiving premium tax credits to purchase health insurance for your family, that could be affected as well.
Financial Planning Solutions For Inherited IRAs
As you can see, inheriting an IRA could lead to a major spike in taxable income, which could affect many other areas of your financial life. If there is any chance that you could be the recipient of an inherited IRA, then you need to think ahead and plan strategically.
It is best to start considering the implications of inheriting an IRA even before the original account owner passes away. What if, instead of leaving the entire $200,000 to you, your father left half to you and half to your mother? Then you would only have to withdraw $100,000 over the ensuing 10 year period and the other half when your mother passed away, which would extend the time you had to take withdrawals. That would be one way to protect you from a major spike in income.
You should also look at your own life situation and future plans when deciding how to empty an inherited IRA. Perhaps you have a young family or want to start one. The IRA could replace one parent’s income for a year or two so that they could stay home with the kids. This would not only smooth out your income for tax purposes but provide a way to invest in your family.
If your kids are a little older, you might opt for a different strategy. Will they start heading off to college in 5 years? Then it might be better to empty the inherited IRA account now so that you won’t have an artificially high income when you start filling out the FAFSA.
How We Can Help
At Guide Financial Planning, we believe that God is the owner of any resources we have and they are to be stewarded wisely. Understanding how an inheritance may be taxed and having a plan to maximize these funds is a part of good stewardship. Finances are complicated, so it’s wise to partner with an experienced financial planner who can guide you as you navigate your stewardship journey, especially with out-of-the-ordinary things like inherited IRAs.
At Guide Financial Planning, we can help you. Whether you just want a strategic plan to implement on your own or someone to manage your inheritance for you, we can do either. Find out more by scheduling a call today.
About Guide Financial Planning
Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner™ and Certified Kingdom Advisor®. He has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.