Prepare Your Kids
How To Inherit Your IRA
Good Morning Relaxing Retirement Member,
I had an extended conversation with a new member last week about the landmines out there when inheriting an IRA as a non-spouse. He’s the executor for his recently deceased sister’s estate. And, although he’s not a beneficiary of her sizable IRA, he has a terrific relationship with his nieces and nephews who will be inheriting her IRA and he knows how much it would have bothered her and her deceased husband if their kids lost money to taxes due to a completely avoidable mistake.
As I was explaining the challenges, it reminded me to pass this along to all of you as well as a year rarely passes without me hearing another horror story in financial circles about families losing half of their parents’ IRA to taxes due to a careless mistake.
If your children are not informed, almost half of your IRA could get lost to taxes in one fell swoop!
That doesn’t sound too inviting, so let’s take this opportunity to walk through the example I shared with him 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.
Frank and Carol
Frank and Carol been married for 48 years and have 4 children who are all out of college and in the workforce.
After Frank retired, he rolled over his 401(k) and pension plan to an IRA where he named his wife Carol as his primary beneficiary and his 4 children as secondary (or contingent) beneficiaries in equal shares.
Three years into retirement, Frank suffered a massive heart attack and passed away. (Sorry for the blunt shock value of the story, but it’s necessary to make the point)
When Frank passed away, as Frank’s spouse and beneficiary, Carol may transfer the money that was in Frank’s IRA into her IRA without paying any taxes.
Key point: ONLY spouses can transfer funds from their deceased spouse’s IRA into their IRA. Non-Spouse beneficiaries (kids, etc.) may not.
Now, let’s fast forward ahead 3 more years. After a long and courageous battle with cancer, Carol passes away.
At this point, Carol’s children have some decisions to make as the beneficiaries of their deceased mother’s IRA.
In far too many situations, here is 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 income 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 40+% of their share in federal and state income taxes in one fell swoop!
In the most recent situation we heard about, over $922,000 went to pay federal and Massachusetts state 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, 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, and each of them has the option of doing this if they choose to. However, as I mentioned, that has enormous tax consequences.
The second option each of your beneficiaries has, which is all too often omitted from the discussion, is to “re-title” their portion to an Inherited IRA, leaving their 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 (similar to your required minimum distribution, but a much lower amount because your life expectancy is much longer), 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, i.e. in the case I referenced, that’s over $900,000 up front!
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.
Next week, I will outline the steps required by the IRS that your children and grandchildren have to follow perfectly in order to qualify.
Committed To Your Relaxing Retirement,
The Retirement Coach
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I appreciate the trust you place in us. Thank you!
(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)