We are on the cusp of one of the most significant economic shifts in modern history – the Great Wealth Transfer. Over the next few decades, an estimated $53 trillion worth of assets will change hands, flowing from Baby Boomers to Gen Xers, Millennials, younger generations, and charities. This massive transfer of wealth presents both opportunities and challenges for inheritors, particularly when it comes to retirement accounts like IRAs.
Trying to figure out the rules surrounding inherited IRAs in a time of grief can be emotionally challenging, even overwhelming. In this article, we aim to simplify some of the more complicated inherited IRA rules so that if you ever find yourself in a similar situation, you’ll already have a strong understanding of your options. This way, you can focus on what truly matters during such a difficult time rather than wasting emotional energy on financial concerns.
The Ten-Year Inherited IRA Window
While the types of inherited IRAs can be intricate, grasping the ten-year rule itself is straightforward. An IRA falls under the ten-year rule if:
- You are neither the spouse nor an eligible designated beneficiary.
- The original account holder had not reached the age for Required Minimum Distributions (RMDs) at the time of death.
- The original account holder died on or after January 1st, 2020.
If you inherit an IRA or 401(K) that qualifies for the ten-year rule, you have ten years to deplete all the assets from it—specifically, by December 31st of the tenth year following the original owner’s death.
The IRS has recently clarified previously murky rules regarding the ten-year rule and RMDs. Now it’s official: non-eligible designated beneficiaries must take annual RMDs within the ten-year period starting from 2025. The choice of when and how much to withdraw each year beyond the RMDs is yours, but you must comply with the annual minimum requirements. That means there are a variety of strategies at your disposal to make the most of your inherited funds and honor the legacy of your loved one.
Approach 1: Opting for a Lump Sum Withdrawal
Choosing a lump sum withdrawal provides quick access to cash, though there are some downsides. First, let’s look at the positives: you won’t have to worry about satisfying Required Minimum Distribution (RMD) requirements, which can be complicated and have negative consequences if you fail to take them. Additionally, you’re removing your funds from market risks; if the markets suddenly drop, you’ll be glad you removed your funds instead of leaving them exposed. Finally, if you have an urgent need for a significant amount of cash, this approach could be beneficial.
However, there are significant downsides. You’ll likely have a sizeable tax bill the year of your withdrawal, and you’re also losing the opportunity for further growth. That said, there are scenarios where it might make sense to take a lump-sum withdrawal, such as during a low tax year, if you anticipate taxes going up in the future, or if you prefer to have a non-taxable asset versus a taxable one.
Approach 2: Even Withdrawals Over Ten Years
Taking even withdrawals over the ten-year period offers a structured approach to managing your inherited IRA. This strategy provides a steady, predictable income stream, which can be helpful for budgeting and financial planning. It also simplifies the process of meeting Required Minimum Distribution (RMD) requirements, as you’re consistently withdrawing funds each year. However, this approach may not be optimal from a tax perspective, as it doesn’t account for potential changes in your tax bracket or fluctuations in the market. You might end up withdrawing more than necessary in some years, potentially pushing you into a higher tax bracket. Additionally, in years of strong market performance, you might miss out on the opportunity to leave more funds invested for growth.
Approach 3: Percentage Withdrawals
Similar to the 4% retirement withdrawal strategy, the percentage withdrawal strategy offers greater overall flexibility than set withdrawals. By withdrawing a fixed percentage of the account balance each year, you’re automatically adjusting your withdrawals based on market performance. In down markets, you’ll withdraw less, leaving more funds invested for potential recovery. In up markets, you’ll withdraw more, potentially taking advantage of a market recovery and further gains.
However, it does come with challenges. Your income will fluctuate year to year, which can make budgeting difficult, and in down markets, you’ll need to ensure your percentage withdrawal meets the minimum RMD requirement.
Approach 4: Tax-Bracket Management with RMD Compliance
This strategy focuses on keeping your tax burden low while ensuring RMD compliance. Here’s how it works: each year, you determine your Required Minimum Distribution, then assess your tax situation. If there’s room in your current tax bracket, you can withdraw additional funds up to the next bracket threshold. This approach offers several benefits: you’re always meeting your RMD requirements, potentially reducing your tax burden over the ten-year period, and maintaining some tax-deferred growth.
However, careful planning and ongoing monitoring of your tax situation are required. You’ll need to stay informed about tax bracket changes and be prepared to adjust your strategy accordingly. Additionally, this approach might not be ideal if you need large sums of money at specific times, as your withdrawals are primarily dictated by tax considerations rather than cash flow needs.
Approach 5: Larger, Uneven Withdrawals Throughout the Decade
This approach involves making significant, irregular withdrawals based on your changing financial needs while ensuring RMD compliance. It can enable you to align withdrawals with major life events or changes in your financial situation. For instance, you might take larger withdrawals in years when you have a lower income or need to make a significant purchase, such as a new car. Just be sure to at least satisfy your RMD requirements in those years you don’t take a larger withdrawal.
Approach 6: Minimal Withdrawals with Final Year Lump Sum
This strategy involves taking only the Required Minimum Distribution (RMD) each year and leaving the bulk of the funds to grow until the final year of the 10-year period. The primary benefit of this approach is the potential for maximized growth within the tax-advantaged account. By withdrawing only the RMD, you’re allowing the remaining funds to continue growing for as long as possible with the hope of having a larger sum. Additionally, if you anticipate being in a lower tax bracket in the future (perhaps due to retirement), you could end up having a lower tax bill on the inherited funds.
However, this approach comes with considerable risks. First and foremost, you’re exposed to significant market risk, particularly as you approach the end of the 10-year period. If there’s a market downturn in or near the final year, your final sum could be significantly smaller than expected. There’s also the tax consideration: by taking a large lump sum in the final year, you might push yourself into a much higher tax bracket, potentially negating any tax advantages you hoped to gain.
In Conclusion
Nothing can be more devastating than the loss of a loved one. And it’s at this time that, in your fragile emotional state, you’re faced with a tough choice – what to do with your Inherited IRA. What makes the most sense for your personal situation? A quick lump sum, strategic withdrawals over the years, or only taking your RMD each year and hoping that you won’t encounter a market downturn in the final years? Would an alternative financial product be better suited for you? And, of course, what about your tax situation and risk tolerance?
Figuring it all out can be messy, especially in times of emotional loss. CPA Retirement Solutions is always available to educate you on your options in these trying times – from the pros and cons of each option to exploring alternative solutions that may better fit your needs. You’re invited to schedule a consultation by clicking the button below.
