How You Can Avoid The $367,000 Mistake

Good Morning Relaxing Retirement Member,

Last week, we talked about the UGLY tax consequences that a gentleman whom I recently met experienced when inheriting his parent’s IRAs.

In short, a $367,000 Income Tax bill!

In this issue of The Retirement Coach Strategy of the Week, we’re going to walk you through the steps to take to avoid this calamity!

To revisit our story for a moment, we were talking about Bill and Agnes 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 Agnes as his primary beneficiary and his 3 children as secondary beneficiaries in equal shares.

Two years into retirement, Bill suffered a heart attack and passed away.

When Bill passed away, as Bill’s spouse and beneficiary, Agnes 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. Agnes 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, Agnes’ 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 Anges’ 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 45% of their share in federal and state income taxes in one fell swoop!

In the case of the gentleman I met, that was $367,000!

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 tax rates 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 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 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’ll choose the Inherited IRA option so they can avoid giving up almost half your life savings!

Committed To Your Relaxing Retirement,

Jack Phelps

The Retirement Coach

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