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When a person passes away, there are many issues for their surviving relatives to deal with- especially financial issues. When a person inherits an individual retirement account (IRA), there are many actions they have to take. However, there are ways that a person can benefit from an inherited Roth or traditional IRA. This TradingSim article will help IRA holders find the best ways to benefit from any kind of IRA, like a SEP IRA.
An inherited IRA is an account that a person inherits after the death of an original IRA holder. After a person inherits an IRA, they have to open another account in their own name with the previous assets.
Because of the COVID-19 crisis, there has been a change in inherited IRA rules. Before the crisis and the end of the stretch IRA, there was a required minimum distribution. By the age of 72, IRA holders must make yearly withdrawals and pay taxes on them as well. However, under the CARES Act, that rule has been waived. Certified public accountant and IRA expert Ed Slott explained the new rule.
“Inheritors get the one year off, a waiver of RMDs. Any beneficiary who doesn’t want to take the distribution doesn’t have to,” said Slott.
With the passage of the SECURE Act and end of the stretch IRA, IRA beneficiaries had to withdraw the funds within 10 years. Slott pointed out that beneficiaries can have a break from the required withdrawal.
“The reality is that many beneficiaries take the money. But now they can take a holiday for a year,” said Slott.
However, Slott noted that low-income beneficiaries may still make the required withdrawal if they need extra income.
“They benefit from being in a lower tax bracket, especially if their income takes a hit this year,” said Slott.
When a spouse inherits an IRA, there are two main options. Adam Bergman is the president of IRA Financial Group and IRA Financial Trust Company. He wrote that keeping the IRA is the deceased spouse’s name is an option.
“The first is you can elect to keep the IRA in the name of the decedent. This is not the most common approach but is frequently used when the deceased spouse is under 72, the required minimum distribution (RMD) age, and the surviving spouse is over 72. This way, the surviving spouse can delay taking an RMD, which will allow the IRA more time to grow without tax,” wrote Bergman.
Bergman wrote that the second and more common option is to move the IRA into their name after their spouse has died.
Gene McGovern is a certified financial planner with McGovern Financial Advisors. He explains the difference between the spousal and non-spousal inherited IRA.
‘A spouse beneficiary, unlike a non-spouse beneficiary, can continue to use the old, pre-SECURE Act rules, either stretching out the RMDs from the account over his or her remaining lifetime or, alternatively, rolling over the inherited IRA into their own IRA instead”, McGovern said.
Financial advice website Kiplinger’s noted the rules for an inherited IRA for a non-spousal beneficiary.
“For most non-spouse beneficiaries, age is irrelevant, and the inherited IRA, whether traditional or Roth, will still need to be emptied by the end of the 10th year after the original owner’s death. The only exceptions to the 10-year rule are for spouses, minor children, disabled or chronically ill individuals, or a beneficiary who is no more than 10 years younger than the deceased IRA owner,” wrote Kiplinger’s.
“As for required minimum distributions, there aren’t any — just the 10-year deadline. You decide when and how much to withdraw, including skipping a year or taking everything out at once. For traditional inherited IRAs, withdrawals are taxed as ordinary income, so let your tax situation determine your timetable for tapping the funds,” added Kiplinger’s.
Kiplinger’s also noted the tax benefits for inherited Roth IRA’s.
“You could spread the withdrawals out evenly over 10 years or withdraw larger amounts in lower-earning years. For an inherited Roth, leave the money to grow tax-deferred inside the account as long as possible and then withdraw it all in the last year. Withdrawals from inherited Roths remain tax-free,” wrote Kiplinger’s.
Gene McGovern is a certified financial planner with McGovern Financial Advisors. He explained the required minimum distribution rules for inherited IRA’s.
“Under the 10-year rule, if a retirement account owner dies in 2020 or later years, a non-spouse beneficiary who inherits that account must withdraw all the funds by the end of the tenth year following the original account owner’s year of death,” said McGovern.
“Under the old rules, both spouses and non-spouse beneficiaries who inherited a retirement account could stretch out the Required Minimum Distributions, called RMDs for short, over their remaining lifetimes,” he said. “This allowed the beneficiary to take advantage of tax-deferred growth in the retirement account over many years, well past the lifetime of the original account owner,” added McGovern.
The end of the SECURE Act also impacts the RMD for inherited IRA’s.
“To put it another way, any successor beneficiary of a beneficiary who was taking RMDs using the stretch method, whether spouse or non-spouse, is subject to the new 10-year rule,” McGovern said. “That’s true whether the first beneficiary inherited before or after the SECURE Act.”
Even though many inherited IRA holders have to make RMD’s, some financial advisers says they should wait. Slott advises Roth IRA beneficiaries to wait to take the mandatory yearly withdrawals.
“I’d be more careful with Roth IRA beneficiaries,” said Slott. “You’d want to hold the tax-free account as long as possible because it’s accruing tax-free.”
Slott also noted that the five-year withdrawal rule can be waived during this time.
“If you inherited in 2015, by the end of 2020, anything that’s remaining in the account must come out. This year, it’s disregarded and becomes a six-year rule,” said Slott.
Financial analyst Dan Moisand advised a client about what to do after he inherited his uncle’s IRA. He noted the tax advantages of inherited Roth IRA’s. Moisand also noted that his inherited Roth IRA’s can’t be converted to a traditional Roth IRA.
“Clearly inherited Roth IRAs are more tax-friendly to beneficiaries than traditional IRAs. I mention inherited Roth IRAs only as an aside. You cannot convert an Inherited IRA to a Roth account. Conversions to Roth accounts must occur before the original IRA owner’s death,” wrote Moisand.
When a person inherits a traditional IRA, unfortunately, they can’t convert it to a Roth IRA. Martin Hauptman is a tax expert at Mandelbaum Salsburg. A client asked him if he could convert his wife’s IRA to a Roth after her death.
“My wife passed away in 2010 and I inherited her workplace IRA contributions. I received the disbursement check in 2011 and promptly created an inherited IRA. About a week ago, I asked the investment company if I could convert it to a Roth and they said no, but I feel they’re giving me the runaround. Can I convert it?”
Hauptman said that he lost the chance to make the conversion.
He told a client that once they inherited an IRA, they can’t make the conversion.
“Once you established the IRA as an inherited IRA you lost the ability to convert it to a Roth IRA,” said Hauptman, a partner in the trusts/estates and taxation groups at Mandelbaum Salsburg in Roseland.
Hauptman said that the client should have designated himself as the IRA owner after she passed away. That would have been a better option than creating another IRA.
“When your wife passed, you should have designated yourself as the IRA owner,” said Hauptman.
Hauptman also said that his client should have completed other steps to make the conversion to a Roth IRA.
“The next step would have been to notify the IRA trustee that you wanted to convert the IRA to a Roth,” he said. “The trustee would have completed any necessary paperwork to document the conversion and ensure that all future withdrawals from the account are tax-free.”
Hauptman also advised his client on what IRS forms to fill out as well to convert an inherited IRA into a Roth.
“You would have completed only part 1 of the form if you are converting part of the account. For any Roth conversions, you would have completed part 2. The amount from line 18 of the Form 8606 is the taxable amount of the Roth conversion,” said Hauptman.
Levine says that traditional IRA’s can’t be converted to inherited Roth IRA’s.
“You cannot convert an inherited traditional IRA to an inherited Roth IRA. That is not allowed in any circumstances, no inherited IRA to inherited Roth IRA,” said Levine.
However, Levine asserts that 401k’s can be converted to Roth IRA’s.
“You can, however, inherit a 401(k) or 403(b) and convert that into an inherited Roth IRA. This feature of 401(k) and 403(b) could be one of several reasons why you might leave your 401(k) with your former employer. But doing so for that reason alone would require a good deal of foresight”, said Levine.
In order to make that conversion, “you would have to weigh your desire to give your children the ability to convert to an inherited Roth IRA from your plan against your desire to do qualified charitable distributions or QCDs during your lifetime. Well, you can’t do a QCD from a 401(k), says Levine.
“Ultimately, you have to put all these factors on a scale and determine what’s most important, says Levine. “And you go from there and you make the best of it because these are the rules we have.”
In addition to Levine, financial planner Joel Frank noted how an inherited IRA can be rolled over into a Roth.
“The inheritance must be rolled into an IRA. It may not be converted to a Roth IRA, even though you are willing to pay the tax. If, however, the inheritance came from an employer-retirement plan like a 457(b), 401(k) or 403(b), you would be allowed to roll over the $45,000 to an IRA and defer the tax or convert the $45,000 to a Roth IRA and pay the tax. This is one case where the taxpayer is willing to pay the tax but the IRS says no thank you,” said Frank.
“Yes, this is peculiar but it’s the tax law. Apparently, the lawmakers wanted to be more flexible when the source of the inheritance was an employer-plan account,” added Frank.
Financial expert Mark Kennan noted that a conversion can happen with a rollover.
“Converting with a rollover isn’t hard to do, but there is a catch. Once you take a distribution from the inherited IRA, you have 60 days to redeposit the money in a Roth IRA. The major hitch is you get 80 percent of the money you request, and Uncle Sam holds the rest until your file your tax return,” wrote Kennan.
He said that if a person doesn’t put all of the amount into a Roth, the unconverted amount is a distribution.
“If you don’t put 100 percent of the amount requested into the Roth IRA, any amount not converted gets treated as a distribution. For example, if you want to roll over $100,000 to a Roth IRA, you get $80,000, but you’d have to come up with the remaining $20,000 from elsewhere. Yes, when you file your income tax return you get that $20,000 back, but by then it’s too late to finish the rollover,” wrote Kennan.
Kennan noted that his client could have transferred the funds from an inherited IRA to a Roth IRA.
“The better option is a transfer, where the bank moves the money straight from the inherited IRA to a Roth IRA without you ever having to touch it. Since it never gets paid to you, you don’t have to worry about the withholding. In addition, you don’t even have to fret about forgetting to put the money into the Roth IRA before the 60-day deadline,” wrote Kennan.
While IRA beneficiaries don’t have to pay required minimum distributions from inherited IRA’s for this year, there is a catch. The American Institute of CPA’s note that if beneficiaries have withdrawn the money, they weren’t exempt in June.
“Treasury and IRS should treat all similarly situated taxpayers the same,” wrote the AICPA in a letter to the Treasury and the IRS.
If an account holder takes up to $100,000 from their IRA’s because of COVID-related expenses, they have three years to repay the money tax-free. However, inherited IRA’s don’t have that protection. The AICPA wants the Treasury and IRS to change that rule.
“Treasury and IRS should allow taxpayers to repay a coronavirus-related distribution taken from an inherited IRA and allow the repayment within 3 years. The taxpayer would not then owe any income tax on the distribution,” wrote the AICPA.
Possibly because of the AICPA’s petition to Congress, inherited IRA beneficiaries can catch a break. If an inherited IRA beneficiary already took their required minimum distribution, they couldn’t put the money back in those accounts. As a result of IRA changes, those beneficiaries had until August 31 to return the funds to their accounts. The IRS’s turnaround surprised Levine.
“Shocking is more indicative of the real feeling here,” said Levine,
Levine thought the IRS was contradicting established law.
“I haven’t spoken to anyone who thought the IRS could do this if they had wanted to,” he said. “They are blatantly contradicting existing law.”
He also believes that the IRS should have worked with Congress before changing the rules.
“It’s one of those things where the Treasury Department and the IRS should work with Congress and say, ‘The next bill you pass this year, let’s make sure you attach an amendment,’” he said. “So it’s done legally and correctly.
Levine said that inherited IRA holders shouldn’t expect such a break next year.
“It’s limited scope and just for this year for distributions that would have been RMDs but for the CARES Act,” said Levine.
Since the required withdrawals are subject to taxes, Levine advises inherited IRA holders to weigh their options.
“The biggest question would be, ‘Do you want to reduce your tax liability? Or do you need the money?’” said Levine.
Levine said that if people are struggling financially, they should make the withdrawal from their inherited IRA.
“However, taking it out this year, if your income is lower — maybe you lost a job — it might not be the worst thing in the world,” he said.
Dan Herron is a CPA and principal of Elemental Wealth Advisors in San Luis Obispo, California. He advises inherited IRA holders to talk to a tax professional to see if their state will go along with putting RMD’s (required minimum deductions) back into their accounts.
“You’re putting the RMD back and it doesn’t count on your federal return, but what happens if your state counts it?” asked Herron.
“These are the kinds of differences you’re going to have,” said Herron.
After August 31, the tax-free return of IRA funds to accounts ended. CPA Ed Slott noted that the regular rules returned.
“The vacation is over and you can’t go back,” said Slott. “Those people who were angry after taking an RMD in January? The IRS gave them until Aug. 31.”
“You took an RMD and want to put it back? Now the regular rules apply,” added Slott.
Because of the CARES Act, there is relief for inherited IRA holders. If an account holder has extra expenses, they can take $100,000 from their IRA without a 10% penalty. Account holders can pay taxes on the contribution withdrawal over three years, according to Levine.
“It doesn’t matter when the withdrawal occurred this year; you would have up to three years to repay it,” said Levine.
If an account holder has COVID or COVID-related economic hardships, Slott says there are ways to help. If an account holder wants to redeposit inherited IRA funds into their accounts, there are forms they can fill out.
“You will have to show the withdrawal as a coronavirus-related distribution on your tax return, which means you’ll need to file a new document known as Form 8915-E”, said Slott.
Another way to minimize taxes is to make itemized charitable contributions of stock. Jamie Hopkins is the director of retirement research at Carson Group. He said giving to charity is a good way to minimize inherited IRA taxes.
“The charitable deduction is the most flexible deduction we have,” said Jamie Hopkins, director of retirement research at Carson Group. “it’s something to consider if you’re concerned about the tax implications.”
Keith Bernhardt is vice president of retirement income for Fidelity Investments. He also recommends that people with IRA’s separate charitable giving from leaving money to heirs.
“You might also want to do charitable giving from an IRA now and leave more money in other assets to heirs”, said Bernhardt.
Merideth Cabrey is the senior wealth advisor at Bedel Financial. She noted that charities can inherit an IRA.
“Designate your favorite charity(s) as the beneficiary of all or a portion of your IRA. Upon distribution, the charity pays no tax and you can leave your more tax-efficient assets to other beneficiaries,” said Cabrey.
Cabrey also recommends naming a charitable remainder trust as a beneficiary.
“Consider naming a Charitable Remainder Trust (CRT) as beneficiary of your IRA(s). The CRT would pay income to named beneficiaries quarterly as outlined in the trust provisions over a term of 10 years or longer, even for their lifetime (as you direct). At the end of the CRT term, the balance of the trust assets would pass to the named charities of the trust,” said Cabrey.
Jeffrey Levine is a CPA and director of advanced planning at Buckingham Wealth Partners. He said that if account holders don’t need to take the required minimum distribution this year, they shouldn’t.
“If you did take it and you don’t need it, hold onto it and look for more guidance from the IRS,” said Levine.
Levine said that if people are financially struggling, they should wait before making required monthly distributions.
“People are still struggling, so if you need the dollars, then you want to weigh all of your options,” said Levine.
Natalie Choate is the lawyer and author of the retirement plan guide Life and Death Planning for Retirement Benefits. She noted that not planning for an inherited IRA could be disastrous for account holders.
“The worst thing to do would be to cash out the plan, put it in your account, and then go see an adviser and say, ‘Now what?’” said Choate.
Frank St. Onge is an enrolled agent at Total Financial Planning, LLC. He advises people to let their inherited IRA’s grow until they reach retirement age.
“If you were not interested in taking money out at this time, you could let that money continue to grow in the IRA until you reach age 72,” said St. Onge.
Carol Tully is a CPA at Wolf & Co. in Boston. She noted that spouses can roll inherited IRA’s into their own accounts and “are able to roll the IRA into an account for themselves. That resets everything. Now they are able to name their own beneficiary that will succeed them and be able to deal with the IRA as if it is their own.”
Choate notes that inherited IRA holders should take note of end-of-year RMD’s. She gave an example of how the RMD’s can hurt an inherited IRA holder.
“Let’s say your father dies Jan. 24, leaving you his IRA. He probably hadn’t gotten around to taking out his distribution yet. The beneficiary has to take it out if the original owner didn’t. If you don’t know about that or forget to do it, you’re liable for a penalty of 50 percent” of the undistributed amount, noted Choate.
“If your father dies on Christmas Day and still hasn’t taken out the distribution, you may not even find out that you own the account until it’s already too late to take out that year’s distribution,” added Choate.
“When you take a distribution from an IRA, it’s taxable income,” says Choate. “But because that person’s estate had to pay a federal-estate tax, you get an income-tax deduction for the estate taxes that were paid on the IRA. You might have $1 million of income with a $350,000 deduction to offset against that.”
“It’s not necessary that you were the person who paid the taxes; just that someone did,” added Choate.
Tully said that inherited IRA holders have to make sure all the names on a beneficiary form are correct. She said financial advisors find those account holders often don’t know the details of their inherited IRA’s.
“You ask who their beneficiary is, and they think they know. But the form hasn’t been completed, or it’s not on record with the custodian. That creates a lot of problems,” said Tully.
M.D. Anderson is the founder of InheritedIRAHell.com and president of Arizona-based Financial Strategies. Because of client errors, Anderson noted that the IRA forms have to be filled out correctly.
“One form like that can control millions of dollars, whereas a trust could be 50 pages. People procrastinate, they don’t update forms and cause all kinds of legal entanglement,” said Anderson.
Another key provision for inherited IRA’s is the disclaimer provision. IRA expert James Lange explained the provision.
“A disclaimer provision allows your named beneficiary to say, “I don’t want this money — give it to the next person in line.” When you include disclaimer provisions your surviving spouse has up to nine months after your death to consider how much to keep and how much to pass on to your children. Your children would also have the option to disclaim to well-drafted trusts for the benefit of their own children,” said Lange.
Choate noted that account holders should talk to a trust lawyer “who’s experienced with the rules for leaving IRAs to trusts.
In addition to Choate, Tully also advises clients to talk to IRA custodians before they get their inherited IRA’s.
“Talk about it with the custodian ahead of time,” says Tully. “Plans are great, but only as far as the ability to have them properly implemented.”
Anderson noted that an account holder has to find the best financial advisor. If they make the wrong decision, it could cause irreversible damage.
‘A private letter ruling involves handing over an IRS fee of about $6,000 to $10,000 and then waiting six months for an answer, ” added Anderson.
If a person really trusts an advisor, they can act as executor of a person’s estate. According to Michael Simmons, director of financial planning at Transitions Wealth Management, that action can streamline financial planning.
“If you can trust the adviser with managing your money, you should also be able to trust them with the responsibility of acting as executor of an estate,” said Simmons. “The same can also be said of other trusted advisers with whom someone may work, such as a banker, CPA or estate planning attorney.”
With inherited IRA’s having to be depleted within 10 years, there can be a quicker depletion of inherited IRA’s. Bill Van Sant is the senior vice president and managing director at Girard, a wealth management firm. He noted the required withdrawal will lead to quicker depletion of inherited IRA’s.
“The result will most likely be a quicker depletion of the inherited IRA but also more of the inherited IRA going to taxes, especially if the beneficiary is working during the time in which they have to spend down this IRA,” said Van Sant.
For account holders, Van Sant recommends a Roth conversion for inherited IRA’s.
“The original IRA owner will begin converting all or part of their IRA into a Roth IRA during their lifetime,” says Van Sant. “Although upon the original owner’s passing, the beneficiaries will still have to deplete the Roth IRA within 10 years, there will be no tax consequences [for the inheritors] as distributions from Roth IRAs are not subject to federal taxes.
“The longer the funds have the opportunity to grow tax-free, the more powerful this benefit has the potential to become,” he says.
Jeffrey Corliss is the managing director and partner at RDM Financial Group at Hightower in Westport, Connecticut. He said that income taxes are the lowest they’ve ever been. Since there are low taxes, he believes now is a good time for a Roth conversion.
“The timing to investigate a Roth conversion is especially critical now, before the current tax legislation sunsets at the end of 2025,” says Corliss. “Given the COVID-19 relief provided by the government and the increased budget deficit, it is highly likely that income taxes, including capital gain rates and estate taxes, could increase in the future.”
Van Sant said a Roth IRA conversion can help with an inherited IRA holder’s taxes.
“You may want to pay the taxes on the converted amount while you are in a lower tax bracket if you think your tax rate will be higher down the road,” says Van Sant.
Van Sant said to consider a person’s tax situation before a Roth conversion.
“You want to pay the taxes due on the conversion from outside assets and not from the converted IRA assets. Due to penalty issues, it is never better to pay with funds from the IRA being converted, especially if you are under [age] 59 ½,” said Van Sant.
Corliss said a Roth conversion can help save a beneficiary and their heirs money.
“Given the change to the stretch IRA provision in the SECURE Act, doing a Roth IRA conversion may make sense and is at least worth looking into with your tax adviser,” says Corliss. “It may save you or your heirs many dollars in income taxes.”
While inherited IRA’s may seem complicated, with planning, caution, and blogs like TradingSim, beneficiaries can navigate how to use these accounts. While beneficiaries miss their departed family members, they can find comfort in the fact that their family members provided for their financial futures with inherited IRA’s.