A year rarely passes without hearing another horror story in financial circles about families losing half of their parents’ IRA to income taxes due to a careless mistake that was completely avoidable.
This always reminds me to reinforce how your kids can properly handle inheriting your IRA so your savings don’t mistakenly end up in the hands of the government.
Landmines are everywhere. If your children are not informed, almost half of your IRA could get lost to taxes in one fell swoop!
That doesn’t sound too inviting, so let’s take this 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.
And, there’s a new unfortunate twist that was built into The Secure Act of 2020 that changes the landscape that you must actively prepare for.
Len and Loretta
Len and Loretta have been married for 38 years and have 4 children who are all out of college and in the workforce.
After Len retired, he rolled over his 401(k) and pension plan to an IRA where he named his wife Loretta as his primary beneficiary and his four children as secondary (or contingent) beneficiaries in equal shares.
Three years after making his retirement transition, Len 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 Len passed away, as Len’s spouse and beneficiary, Loretta may transfer the money that was in Len’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, Loretta passes away.
At this point, Loretta’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’s 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!
In the most recent situation we heard about, that amounted to over $1 million that went to pay federal and Massachusetts state taxes.
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.
The amount of money saved in the short term and the long term is staggering, i.e. in the case I referenced, that’s over $1 million up front!
Prior to the passage of The Secure Act in 2020, your kids would only have to take a small annual taxable distribution from your IRA each year based on their life expectancy. This allowed them to stretch the tax burden over their lifetime leaving the rest of the funds inside the IRA to grow tax deferred.
The new unfortunate twist that was built into The Secure Act in 2020 was they now only have ten years with which to stretch the tax burden. In short, they must withdraw all of the balances by the end of the tenth year after your passing.
The key differential, however, is there is no mandatory annual distribution. Your children/beneficiaries have the option to withdraw as little or as much as they wish each year. They simply have to remove all funds by the end of the tenth year.
This requires significant planning on their part. Is it better to take an equal amount each year, or is better to let funds grow tax deferred and pull more out in later years?
This ideal strategy will depend on their need for the funds, their income tax bracket each year, and their ability to anticipate higher income tax rates that may or may not come with future legislation.
Given the current climate in Washington, it’s highly likely that we will see higher income tax rates in the future so this has to be taken into consideration.
** 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 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 in one fell swoop!