3 mistakes beneficiaries should avoid when inheriting an IRA



Changes to the tax law in the Secure Act eliminated the Extended IRA for most beneficiaries inheriting from an IRA or 401 (k). Most beneficiaries who inherit from an IRA will now have to follow the 10-year rule, which can significantly increase income taxes owed on an inheritance.

The good news is that expandable IRAs are still available to recipient spouses. For most beneficiaries other than the spouse (think kids, friends), the Scalable IRA option has been replaced with a new 10-year payment rule. This rule required that IRA beneficiaries completely empty an inherited IRA balance at the end of the tenth year after death. The new rules apply to IRA beneficiaries who received an inheritance in 2020 or later.

For those who already had an inherited IRA before 2020, don’t panic; you can still follow the old extensible IRA rules. This will allow you to take the minimum required distributions from your Inherited IRA over your lifetime. Likewise, spouses and other “eligible named beneficiaries” are also exempt from the new rules and can still potentially benefit from the extended IRA. Spouses inheriting from an IRA can also often simply transfer the inherited IRA into an IRA on their own behalf.

It is imperative that you recognize to which category of beneficiaries you belong. This will determine the legacy IRA payment options available to you. For those who receive substantial inheritances through IRAs or other retirement accounts, making mistakes with this process can result in paying far more taxes than necessary.

The three categories of beneficiaries under the security law are:

• non-designated beneficiaries, or NDB (no designated beneficiary). The eventual heir will not be able to benefit from the extendable IRA.

• Ineligible Designated Recipients, or NEDBs. NEDBs are also not eligible to use the Extended IRA. They will be subject to the 10-year rule.

• eligible designated beneficiaries, or EDBs. Eligible designated beneficiaries are eligible to use the Scalable IRA.

Here are three mistakes people inheriting retirement accounts should avoid.

1) Take a lump sum distribution from an inherited IRA

For those fortunate enough to inherit a large IRA or other retirement accounts, the tax savings from the old extended IRA and the current 10-year rule could be substantial.

For example, suppose you are going to inherit a two million dollar IRA. If you ignore smart tax planning and take out all of the inheritance in one lump sum, you will be inundated with taxes. Depending on your own income and marital status, up to three-quarters of this inheritance could end up in the top 37% federal bracket. I am a financial planner in California who would also be subject to an additional state tax of up to 13.3%. Spreading withdrawals over ten years can help a lot of taxing your estate in lower tax brackets at the federal and state levels.

In case it is not clear, income in the top federal and California tax brackets is taxed at 50.3% (37% federal, 13.3% in California). It is a tax of $ 1,006,000 income tax. You would likely see further cost increases if you were on Medicare, have other income, as well as the Obamacare surcharge of 3.8%.

2. Not understanding the options for spouses inheriting an IRA

There are several options for spouses when they inherit an IRA. They can perform a spousal rollover, which essentially means moving the inherited IRA money into an IRA in their own name. They can do an extended IRA or follow the 10 year rule. As a general rule, if the money is not needed now, you should consider doing a spousal rollover. If you need the IRA money to live today (and you’re under 59.5), there may be reasons to combine the spousal rollover with an extended IRA.

3. Mix Pre-2020 Rules and Secure Act Rules for Legacy IRAs

Tax law is complicated enough, but when tax rules change, there is almost inevitably confusion. There are a large number of pre-2020 IRA recipients who are told that they are not eligible for an extended IRA, which is just hogwash. They can still use this option. The Secure Act does not change their payment schedule.

On the other hand, there are post-2020 IRA heirs who are mistakenly told that they are eligible to extend their legacy IRAs when they are not actually eligible. Depending on your overall tax situation, this could mean making taxable withdrawals from your Inherited IRA, which could result in high taxation of your inheritance.

The biggest barrier here is the people not realizing that they are eligible designated beneficiaries or POEs. This is the group of beneficiaries who can still benefit from the Extended IRA, regardless of when the deceased owner of the IRA has passed away. Missing out on this distinction could lead you to a bad withdrawal schedule, pushing your income into higher tax brackets than necessary and dramatically increasing your lifetime tax bill.

Who is an eligible designated beneficiary?

An Eligible Designated Beneficiary (BDE) is always a real person. Simply put, a trust, charity, estate or corporation will never be an eligible designated beneficiary. Here are the five categories of people that are included in the EDB classification:

1. The surviving spouse of the pension account holder

2. The child of the holder of the retirement account who is under 18 years of age

3. A disabled person

4. Someone with a chronic illness

5. Anyone else who is not more than ten years younger than the deceased owner of the IRA

In most cases, EDBs will be able to withdraw from their inherited IRAs based on their own life expectancy.

Receiving an inheritance can be emotional and stressful. Be sure to seek advice from a trusted certified financial planner and tax professional to help you understand your options with an Inherited IRA as well as have a plan to minimize taxes on your inheritance.


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