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Don’t Let Your Kids Lose 40+% of Your IRA

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 that was completely avoidable.

In the most recent situation we heard about, over $922,000 went to pay federal and Massachusetts state taxes.

This, and the countless questions I receive from members on this topic, always reminds me to reinforce how your kids can properly handle inheriting your IRA so almost half of it doesn’t mistakenly end up in the hands of the government.

Let’s take an opportunity to walk 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.

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 is 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!

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 and 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 two steps your children (beneficiaries) must take by December 31st of the year AFTER you pass away:

  • They must re-title your IRA as an Inherited IRA naming themselves as beneficiary.  (This has to be done with an IRA custodian who can/will do it.  Not all of them will do it.)
  • 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 your beneficiaries are aware of this option as you can’t do it for them before you pass away.

Unfortunately, most people are not aware of this.

After they examine all of their options, some of your beneficiaries may choose to receive your IRA in a lump sum (or partial 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 will choose the Inherited IRA option so they can avoid giving up almost half your life savings!