STOP Making These Inherited IRA Mistakes! Everyone is a Target

How do you deal with inherited IRA? The rules have changed pretty significantly with SECURE Act 2.0. Now, the type of beneficiary and the age of the original account owner typically determines the actions you can take. You, as the new owner, must withdraw their remaining RMD before the end of the current year. You have to do this before you do anything else, or you risk paying up 25% penalty.

Welcome back to We're Talking Money. I'm Phil Clark, your host, and this channel is all about breaking down complex financial topics so you can make informed decisions. Let me just give a shout out to one of our viewers. He asked the question, how do you deal with inherited IRA?

Since the passing of SECURE Act and, of course, SECURE Act 2.0, navigating this inherited retirement account business has become pretty tricky. Even financial planners and wealth advisors, these are seasoned veterans, they're scratching their heads over some of the nuances. We have things like eligible designated beneficiaries, we have designated beneficiaries, spousal beneficiaries, and something called non-individual options. Well, what is that exactly? Fear not, because today we're going to demystify these mysteries of inherited IRAs, and I'm going to equip you with some strategies that will help you maximize this newfound wealth.

Exactly what is an inherited IRA? Simply put, it's an IRA that you inherit after the original owner passes away. But here's where it gets interesting. The rules have changed pretty significantly with SECURE Act and SECURE Act 2.0. They impact how quickly you must withdraw the funds and how they're taxed. Now, the type of beneficiary and the age of the original account owner typically determines the actions you can take when you inherit a retirement account.

However, if the original account owner was of what's called the required minimum distribution age but had not taken all RMDs before their death, you, as the new owner, must withdraw their remaining RMD before the end of the current year, or you risk paying up to 25% penalty on the amount that was supposed to be taken out. You have to do this before you do anything else. With that said, let's look at your options, including distribution requirements and the potential tax consequences.

So number one, you could do something called disclaim the inherited account. Regardless of your relationship with the account holder who offit to leave it to you, you can still disclaim the inheritance. Now, you might be asking, why would anyone do this? Why would you disclaim free money? Maybe you would do it because you're in a financially secure position and you want to avoid any potential tax consequences. You have nine months to make this selection. So if you've got lots of income, or maybe you're in a really high tax bracket, you might not want that money.

The second option would be to take it in lump sum. As the beneficiary, you may distribute the account assets in a lump sum, and you don't have to worry about the 10% early withdrawal penalty. If you inherit a Roth IRA, the account must have been open for at least 5 years. Say they had it for three, means you have to leave it in place for two more before you can get the withdrawals without the penalty.

Now, the third option, this one is only for the surviving spouse. So if you are a spouse and you're listed as the beneficiary, and of course I hope you are, you have the option to roll over the funds to your own IRA, where the money grows tax-free. That said, if your spouse was subject to required minimum distributions and they had not taken the whole amount, you will have to remove that undistributed RMD before you make the transfer and before you really do anything with that inherited account.

Number four, you could open a stretch IRA, but the old stretch provisions were eliminated back in 2020 when the SECURE Act became law. This is where those eligible designated beneficiaries come in, and the stretch, the old stretch, it's still available for them. Now, what is an eligible designated beneficiary? Well, that could be a spouse, that could be a minor child, or beneficiaries less than 10 years younger than the account owner, and lastly, disabled or chronically ill beneficiaries.

Now, I want to say something about minors. Yes, the minor can qualify for the old stretch, but it only lasts until they reach age 21. When they reach age 21, their distribution goes back to the mandatory 10 years.

Number five, you could distribute these assets within 10 years. I just talked about that. That was made possible, if you will, by SECURE Act 1.0, and it is straightforward, just like it says. Everything in that inherited retirement account must be withdrawn by the end of the 10th year to avoid penalties on the undistributed amount.

Let's get practical here. Here are some strategies to help you make the most of this inheritance. Number one, you need to assess your options as early as possible. And what I mean by that is understand whether you qualify for the 10-year rule of distribution, the five-year rule of distribution, and you want to plan accordingly. Planning will help you make the most of this new money.

Number two, you want to consider stretching within limits. Stretching means the money gets to stay in place longer, enjoy tax-free growth or tax-deferred growth, and that means you can increase the value over time in a much more tax-efficient way. The original stretch IRA, it's gone, but the restricted version is better than nothing.

Number three, tax efficiency. I can't stress this one enough, because taxes, after all, can really strip away potential for greater wealth. How you can minimize taxes on withdrawals, it really boils down to this: strategic planning. It's how do you make distributions? What distribution schedule is best for you? Is it equal payments over 10 years? Is it some payments in the first few years, maybe skip a year or two, and then pick up again in maybe year 7 through 10? Or do you wait until the 10th year?

All of that matters, and it really matters what type of income you have. Are you expecting that to go up, go down? Are you about to retire? Lots of variables here. So you want to make sure you have a conversation about what opportunities exist for you based on your situation.

And number four, you want to evaluate conversion opportunities. Now, depending on your tax bracket and financial goals, converting an inherited IRA to a Roth IRA might be advantageous. Haha, if it were legal. You're not allowed to do that. But in just a minute, I'm going to talk about inheriting a 401k, and that can be converted to a Roth. Stand by.

So how can beneficiaries maximize the value of that inherited IRA? Well, first, if you inherit a traditional IRA, remember, you must empty the account by the end of year 10. Now, spreading those distributions over 10 years, that's probably going to be your best bet, but depending on your situation, customized distributions might be a better option. If you don't know how to figure that out, reach out to your financial professional. If you don't have one, you can reach out to us. We're happy to help you run those numbers so you can make a better decision.

Let's talk about the pros and cons of converting an inherited IRA to a Roth IRA. First, the unfortunate answer is you can only do this if you are the spouse. If you're not the spouse, converting to a Roth is just off the table. Sorry about that. You've probably heard people say this is doable. Believe me, it's not.

Now, there is a little-known rule that does allow an inherited 401k plan to be converted to a Roth IRA. This is a huge opportunity if someone is leaving you an account that is still labeled, or is still in their company 401K plan. But please be sure to get proper tax advice before pulling that trigger, since the conversion is fully taxable. Once you make the conversion, that inheritance will never be taxed again. That's powerful.

So at this point, you are equipped to navigate the complexities of inherited IRAs, and I think you can do it with confidence. Remember, the key is to understand your options, plan strategically, and seek professional advice if you're not sure in the direction you need to go. Don't forget to like, share and subscribe, and I'll see you next time on We're Talking Money.