Landmines When Inheriting Your IRA
Having to deal with the emotional and psychological effects of losing a spouse or parent is always difficult.
Having to also deal with their financial affairs and the tax implications is enough to put you over the edge. The consequences of making a wrong decision are enormous.
Landmines are everywhere, especially when your family inherits your IRA and 401(k).
I’d like to walk you through an example of how your children and grandchildren can make an “informed” decision when they inherit the IRA that you’ve taken your entire lifetime to build.
Bill and Sally
Bill and Sally been married for 40 years, and 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 (or contingent) beneficiaries in equal shares.
Two years into retirement, Bill suffers a heart attack and passes away. (Sorry for the blunt shock value of the story, but it’s necessary to make the point)
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.
At this point, Sally’s children have some decisions to make as the beneficiaries of their deceased mother’s IRA. In far too many cases, here’s what happens:
They call the institution where the IRA was held (bank, investment firm, insurance company, etc.) to inform them that their mother has passed away and to find out what their options are.
Depending on who receives that phone call, here’s the answer that they’re likely to hear:
“We’re very sorry to hear about your loss. We’re going to send you out an IRA distribution request form. Please each sign the form and return it to us along with a certified death certificate and we’ll get the checks out to you within 7 to 10 business days.”
Sounds simple enough, right?
What just happened?
Income Taxes Now Due on the Entire IRA
The children just paid taxes on the entire balance of the money in the IRA!
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 their mother’s IRA was $250,000. That means that as much as $100,000 would instantly go to pay federal and state income taxes!
Imagine that. You work your entire life. You diligently save your money. You select sound investments. You do everything right and with one phone call to an uninformed company representative, 35-40% of your hard-earned savings is gone in one shot!
What Should They Have Done?
Each of the kids actually had another option with their share of their mother’s IRA. One option was to just cash it all out. But, as I mentioned, that has enormous tax consequences.
The second option, which is all too often omitted from the discussion, is to “re-title” their portion to an Inherited IRA, leaving their deceased mother as the deceased owner of the IRA and them as the beneficiary.
By doing this, they are only required to withdraw and pay taxes on a small amount of the money from the IRA each year, leaving the rest to grow tax deferred for the rest of their lives if they wish!
The amount of money saved in the short term and the long term is staggering.
Now, in order to qualify for this “Inherited IRA” tax deferral plan, there are certain IRS requirements that they have to fulfill in order to make it work.
In the near future, I’m going to outline the steps required by the IRS that your children and grandchildren have to follow perfectly in order to qualify.