How Your Family Can Benefit From “The Inherited IRA”

Last month, we talked about the tax consequences awaiting your family when they inherit your IRA.

To revisit our story for a moment, we were talking about Bill and Sally who have been married for 40 years.  They have 3 children who are all out of college and in the workforce.

After Bill retired, he rolled over his 401(k) and pension plan to an IRA where he named his wife Sally as his primary beneficiary and his 3 children as secondary beneficiaries in equal shares.

Two years into retirement, Bill suffers a heart attack and passes away.

When Bill passes away, as Bill’s spouse and beneficiary, Sally may transfer the money that was in Bill’s IRA into her IRA without paying any taxes.  (Key point: ONLY spouses can do this.)

Now, let’s fast forward ahead 3 more years.  Sally gets sick, and after a long battle, she passes away.  (Again, sorry for the bluntness of the story, but it’s necessary to properly make the point.)

At this point, Sally’s children have some decisions to make as the beneficiaries of their deceased mother’s IRA.

If they choose the path of least resistance and simply withdraw the entire balance in Sally’s IRA, the entire balance is taxable at ordinary income tax rates.

Depending on their own personal tax brackets, it’s likely that they gave up 35-40% of their share in federal and state income taxes in one fell swoop!

Let’s suppose that each of their shares in your IRA was $250,000.  That means that as much as $100,000 would instantly go to pay federal and state income taxes for each of them!

Option #2

Their second option is to establish an “Inherited IRA” upon your death which would allow the money in your IRA to continue to grow tax deferred for the rest of their lives.

The potential tax savings from this option is enormous.  Imagine your money continuing to grow without taxes for decades vs. withdrawing and paying ordinary income taxes on the entire balance up front, and then reinvesting what’s left over.

However, in order to qualify, there are two steps your beneficiaries must take by December 31st of the year AFTER you pass away:

  1. They must re-title your IRA as an Inherited IRA with themselves as beneficiary.  (This has to be done with an IRA custodian who can/will do it.  Not all of them will do it.)
  2. They must take a small required minimum distribution from the Inherited IRA each year (similar to your Required Minimum Distribution you must take at your age 70 ½.) However, it’s based on their life expectancy, not yours, so the amount they must withdraw and pay taxes on is much less.

The key is to make sure they are aware of this option.  Unfortunately, most people are not aware of this.

After they examine all of their options, some may choose to receive your IRA in a lump sum and pay the taxes up front.  That’s fine as long as they’re making an educated decision.

However, once they realize the short and long term advantages, it’s highly likely that they’ll choose the Inherited IRA option.