Many American retirees make significant mistakes with their traditional IRAs by planning to leave the accounts to their children or other heirs.
Inheriting a traditional IRA has never been a big deal, and it’s significantly less attractive to heirs today. An IRA owner can take steps to increase the value of inherited assets.
Most other assets are inherited income tax-free, and the heir increases the tax basis to the current market value. The heir can sell the assets immediately and does not have to pay capital gains or income taxes, regardless of how much the assets increased in value during the previous owner’s holding period.
With a traditional IRA or other retirement account, there are still no immediate taxes when the beneficiary inherits it. However, the beneficiary must pay taxes on distributions made from the traditional IRA or 401(k), just like the previous owner.
In fact, a beneficiary only inherits the after-tax value of a traditional retirement account.
Those have always been the rules. The SECURE Act, which went into effect in late 2019, made an inherited traditional IRA even less attractive.
Before the SECURE Act, beneficiaries were required to take required minimum distributions (RMDs) each year, but in many cases the RMDs could be spread out over the beneficiary’s life expectancy. This limited distributions and allowed the IRA’s tax-free compounding to work for a long time.
If the beneficiary wanted or needed additional money in a year, more than the RMD could be paid out.
This practice was called “Stretch IRA.”
The SECURE Act eliminated the stretch IRA for IRAs inherited after 2019. Now, most beneficiaries of traditional IRAs must distribute the entire IRA within 10 years, known as the 10-year rule.
There are exceptions to the 10-year rule for five types of beneficiaries: surviving spouses, beneficiaries under 21, disabled or chronically ill individuals, and beneficiaries who are less than 10 years younger than the deceased owner.
The IRS has made inheriting a traditional IRA even more complicated in recently issued final regulations. If the original owner of the traditional retirement account was taking RMDs at the time of death, the beneficiary must take annual RMDs in years one through nine after the inheritance and fully liquidate the account by the end of year ten.
The 10-year rules also apply to inherited Roth IRAs, but distributions are tax-free and annual RMDs for years one through nine are not required.
For at least a few years, mandatory distributions from an inherited traditional IRA will likely increase the beneficiary’s adjusted gross income enough to move him or her into a higher income tax bracket. The distributions could also trigger or increase one or more hidden taxes, such as the surtax on Medicare premiums or income taxes on Social Security benefits.
The younger the beneficiary, the more severe the application of the 10-year rule. For example, before the SECURE Act, a 22-year-old beneficiary could spread out distributions from the inherited IRA over age 63.
The effects of the SECURE Act could be more severe in the future.
The 2017 tax cuts are set to expire after 2025 unless Congress agrees on a plan to extend them for at least some taxpayers. In addition, the growing federal budget deficit and debt could lead to higher income tax rates in the coming years, at least for high-income taxpayers. Taxpayers who take mandatory distributions from significant inherited IRAs will likely be among high-income taxpayers for at least a few years.
For beneficiaries who want to spend inherited IRA funds as quickly as possible, the changes to the SECURE Act are irrelevant.
The changes also don’t mean much for IRA holders who have to fund their retirement savings with their traditional IRAs.
However, a significant minority of retirees have enough income and assets outside of their IRAs that IRAs are not their primary source of retirement savings. They view IRAs primarily as reserve accounts to be left primarily to their heirs.
Holders of traditional IRAs in this category should consider other strategies that reduce family income taxes and increase beneficiaries’ after-tax wealth.
By using one or more of these strategies, you can avoid paying income tax on the traditional IRA, which is essentially a tax-free gift to heirs. You receive the full benefit of the inheritance, not just the after-tax amount.
You can also plan when taxes will be paid, which will likely result in a reduction in taxes payable.
Perhaps the most commonly used strategy is to convert all or part of your traditional IRA into a Roth IRA. You include the converted amount in gross income and pay income tax on it, preferably using resources outside the IRA.
The capital gains from the Roth IRA are compounded tax-free and ultimately paid tax-free to you or your beneficiaries.
Another option is to take withdrawals from the traditional IRA when you are in a relatively low tax bracket. This may be in the early years of retirement, before you start taking RMDs. Or there may be years when your income is lower or you have higher deductions.
Pay taxes on the distributions and invest the taxed amount in a taxable investment account. You may invest in the account primarily to generate long-term capital gains or other tax-advantaged income.
The benefit of the taxable account, as I said, is that when the assets are inherited, the heirs increase the tax basis of the assets to their current market value. There are no capital gains taxes on the increase in value of the taxable account.
Or they can continue investing in the account. They only have to pay taxes on the capital gains and income they have earned after the inheritance.
Another option is to convert the traditional IRA into a permanent life insurance policy.
This is a flexible strategy that can be structured to meet your goals and needs.
You could withdraw the traditional IRA balance in one lump sum, pay income taxes, and put the taxed amount into a term life insurance policy.
Or you can take annual distributions, such as RMDs, and pay the after-tax amount as an annual premium into a life insurance policy with a fixed term.
Or the policy could be held in an irrevocable trust. The trustee receives the proceeds from the policy upon your death and then invests and distributes the money according to the terms you set out in the trust.
The proceeds from the insurance policy are tax-free, regardless of whether they are received directly by the heirs or by the trust.
For many people, the benefit paid from the insurance policy exceeds the pre-tax amount that was included in the traditional IRA.
Another benefit of the insurance policy is that the benefit paid to your beneficiaries does not rise and fall with market fluctuations. The benefit is either fixed or increases over time, depending on the type of policy you purchase.
