Inherited IRA Rules & Regulations Explained

At The Wealth Cafe, we’ve noticed that there is an underlying assumption that inheriting a retirement account is simple, but changes to certain rules have made it a little more complex than most people realize. Since post-pandemic AKA 2020, someone who inherits a non-spousal IRA needs to be aware of important tax rules and distribution requirements that come with it. In this episode, we’ll be breaking it all down, so you and your loved ones better understand these rules, as well as avoid costly tax mistakes.

What we’ll cover:

✅ What the 10-year rule really is.

✅ Differences between Traditional vs. Roth inherited IRAs.

✅ How inherited IRA withdrawals can affect tax brackets and income.

✅ Planning strategies to reduce taxes for future generations.

We’ve seen a lot of instances where beneficiaries inherit IRAs during peak earning years and then due to withdrawals end up unknowingly increasing taxable income, pushing themselves into a higher tax bracket, and negatively impacting things like financial aid eligibility. So, as we always say, we’d recommend working with your financial team and planning early, so that you can implement strategies that can help preserve more of your wealth for future generations.

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Transcript

SPEAKER_00 0:16

Most families think that inheriting a retirement account is a pretty straightforward transaction. But in a post-COVID world, aka after 2020, the tax rules have changed quite a bit, and it's something that you need to be aware of. Now, more specifically, tonight on The Wealth Cafe, we are going to be talking about what it means to inherit a non-spousal IRA. The rules when you are passing money from one spouse to another in an IRA look a little different, and we'll be talking about that at a different point. So tonight we're gonna focus on when you are leaving money or when you inherit money from somebody who is not your spouse. And this could be anyone from your parents, grandparents, maybe your cousin, or even if the neighbor next door decided to leave you some money. You never know. So these are the rules that you need to focus on when it comes to the non-spousal IRA. One of the first things I want us to break down is what the 10-year rule is. Now, this is something you're gonna hear a lot about when inheriting a non-spousal IRA. And there are two key parts that you need to know about this 10-year rule. Now, the first thing you need to know is whether the person that had passed away and left you this money behind had been taking RMDs or required minimum distributions. Now, if this person hadn't taken their RMDs yet and hadn't started them, wasn't required to by the IRS, this then means that you can take the money out over 10 years at any pace you want. For example, if in year one you want to take out$50,000, and then in year two, you want to take out$200,000, and in year three, you want to take out$0, you have that kind of flexibility. The only thing that you need to know is that all of the money must leave the account by year 10 and the end of that 10th year. Now, let's say the person had been taking RMDs. You need to make sure that during that 10 years, you are taking at least their required minimum distribution every year during those 10 years. Once again, the account does need to be cleared and zeroed out by the end of that 10 years. So you can take more than you want. Let's say in year one, they have a required minimum distribution of$50,000. You can take out$60,000 or$70,000. You can take out as much as you want. The RMD in the following years will then be recalculated, but you need to make sure that by the end of year 10, you have taken all of that money out. Now, why does it matter whether you are inheriting this money from a spouse or not, or if you are also considering leaving money behind to a non-spouse? The tax implications can vary on whether this is a traditional versus Roth IRA. I talk a lot about with clients what does it mean to do Roth conversions and the impact that will have during your lifetime and also the generations to follow. Statistically speaking, we see most people receive an inherited IRA and have that money come into their life during their highest earning years, especially as baby boomers are passing away. More and more people are living longer, later in their lives, later and in those higher earning years of their careers. And that's when they are receiving the money, which means if you are having to take out large sums of money from an inherited IRA every year, that is adding to your taxable income. And that can make such a difference on leaving behind traditional or Roth IRA money. Now, the rules still apply in terms of that 10 years that we just talked about. You will still have to take out the money over a 10-year period, but with a Roth IRA that you inherit or leave behind, you don't have to take out those required minimum distributions. You could decide to take out all of the money in year one or in year 10 if you want to let the money just sit there and grow for that period of time. The other key thing to note is if the money is in a Roth, as long as you are following all the rules, working with your financial team, that should not be counted in your ordinary income for any of the years that you are taking that money out. That can have a huge implication on your financial picture. To give you an example, let's say you have an inherited IRA that has a million dollars in it that you've just received from a relative that passed away, non-spouse. So we've already checked that box, which means the 10-year rule is going to apply. Let's say the RMD is$100,000 that you are required to take out that year. If you are then being pushed into a higher tax bracket, let's say you go from 32 to 35, you will then be paying 35% on that$100,000. You're not going to pay that on all of your ordinary income for that year because we know marginal tax rates exist. But if it's pushing you into a new tax bracket, you're going to end up paying$35,000 in taxes. This is versus having a Roth come into your life. And if you take out$100,000 that year by choice, that$35,000 that you would have paid in taxes isn't going to occur because you don't have to add that$100,000 to your ordinary income. Now, one example I can give you of why this has such a big implication. I had a client of mine who they were two teachers and they worked incredibly hard to prepare their kids for college. And they were really smart girls and were so excited that they were going to be getting a lot of needs-based scholarship and aid to the schools that they wanted to go to. However, six months before their intended start date for college, they received the family and inherited IRA and now had a huge lump sum of money come into their lives. Because of the 10-year rule, they had to take RMDs because the non-spouse that left the money behind had already started their RMDs. So they were required to take out money every single year, which made the parents' income look higher than it really was. Yes, they did have this money coming into their life, but it wasn't enough to pay for school. But in the school's eyes, they didn't look as though they needed a lot of this need-based aid scholarship that they were being offered. They ended up losing a good portion of it and then had to turn to take out student loans to help make up the difference. Because a lot of this happens during those highest earning years or during really critical years, like grandkids going to college or even retirement, this can have a huge impact. And it's something to keep in mind as you are either planning your own estate and thinking about what assets you want to leave behind, or as you're working with the loved ones in your life and trying to figure out what assets are they going to leave behind for me. One of the key considerations as you are trying to figure out what to leave behind in your estate, or if you're helping navigate a loved one planning their estate, take a look at their current tax bracket versus the tax bracket that you could be in. Once again, we'll never get it 100% right because we don't have a crystal ball. But this is a great time to pull in people like an accountant, like a financial advisor, and build your financial team because they will be able to help you navigate, although they don't have a crystal ball, so to the best of their abilities, what it looks like to do either Roth conversions during the lifetime of the person leaving behind that money versus what it would look like for the person inheriting that money. These are really key things to look at because we never want to pay more taxes than we need to. So figuring out what strategy works the best. And it's never a one-sum game. It might be let's convert some of this during the lifetime of the person going to pass. And then the other amount or the other half, whatever ratio that is, can be converted for the person that's going to inherit the money. And they can work and help you strategize what makes the most sense given where they are right now, between income, tax brackets, and also looking at that next generation. To summarize all the things we have talked about, the biggest thing that you need to take away from this episode is making sure you are planning for what you are going to inherit, working with your loved ones and helping them figure out the strategy that works best for both them and you to maximize and really utilize the money that they are spending during their lifetime and also that you could potentially inherit. Now we can never fully plan for these, and a lot of people don't like to fully talk about their funds, but send them this episode, share the link with them just to plant the seed and get them thinking about it, and also use this to plan and strategize in your own life. The best thing that you can do in any of these situations is plan, prepare, and work with the people that can help you figure out the best strategy to maximize the money that you are being given or leaving behind to make sure it's not just being all spent away on taxes. Thank you for joining me on tonight's episode of The Wealth Cafe, and I look forward to seeing you again soon.