Navigating Tax and Investment Consequences of Inheriting an IRA: A Down-to-Earth Guide
Rory O'Hara, CFP®, CRPC®, is the visionary behind Ausperity Private Wealth as its founder and senior managing partner. Many adults find themselves inheriting an IRA, yet lack a solid grasp of the principles and potential tax implications involved in managing such an account. The topic's complexity and association with death often lead to avoidance, with many adults failing to draft a will or estate plan.
The inherent complexity of IRAs and the negative connotations surrounding the subject of death contribute to this issue. To avoid potential pitfalls, it's crucial to understand the consequences of quickly liquidating an inherited IRA (taxes!) and the penalties for not acting promptly enough. However, there are other considerations to keep in mind as well.
Traditional vs. Roth IRAs
Understanding the taxation differences between traditional and Roth IRAs is equally important. Traditional IRAs are funded with pre-tax income, collecting tax accruals over time. Roth IRAs, on the other hand, contain post-tax assets that grow tax-free and are also tax-free upon withdrawal.
Inheriting an IRA often means adhering to these same principles – although there are some nuances. For non-spouse beneficiaries, handling a Roth IRA is relatively straightforward. They have a decided 10-year window (from the time of the original account holder's death) to liquidate the account. There are no mandatory distribution requirements, and the withdrawal remains free of tax.
Inheriting a traditional IRA, however, introduces a degree of complication. If the deceased account holder had been taking required minimum distributions (RMDs), then the beneficiary must follow the same practice, distributing funds in line with their own life expectancy, and liquidating the account within the 10-year window. In contrast, if the original account holder wasn't taking RMDs when they passed away, the beneficiary is not obligated to adhere to them, but the 10-year rule still applies.
Investment Decisions
The differing tax treatment can also influence investment strategies within an inherited IRA. For example, if an invested heir receives a youthful and financially secure Roth IRA, they might consider investing in high-growth, aggressive holdings and wait for the balance to grow tax-free for 10 years before taking the tax-free withdrawal.
Traditional IRAs, which incur taxes on withdrawals, may lead to a more conservative, balanced approach, especially considering the potential tax liability for deferring withdrawals beyond the 10-year window. Additionally, most heirs should aim to drawdown the balance somewhat annually, even if they aren't subject to RMDs, which can help reduce the likelihood of an oversized tax burden at the end of the 10-year period.
Generational Planning
IRA owners don't always need to directly transfer IRA assets to their heirs. Many high-net-worth individuals establish a trust as the beneficiary, offering them greater control over inheritance management.
Through a trust, the owner can impose certain limits on the distribution process, aiming to provide financial guidance and responsibility to their heirs in a tax-efficient manner. Placing a trust-like mindset on inherited funds can be beneficial, viewing the inheritance as a long-term advantage rather than a prize to be spent thoughtlessly.
Inherited wealth is sometimes challenging to preserve, as people often spend inherited funds more frivolously than their own savings. This disparity is why financial advisors commonly observe more caution with earned and saved money than with inherited wealth.
Professional Guidance
When dealing with inherited IRAs, every individual's circumstances vary, making professional financial advise invaluable. A knowledgeable advisor can help you make customized decisions that align with your specific needs and objectives.
In summary, understanding the intricacies involved in inherited IRA management and seeking expert advice is crucial for preserving and maximizing the wealth left to you.
Rory O'Hara, with his expertise as a CFP® and CRPC®, could provide valuable guidance on managing an inherited IRA, given his experience in private wealth management.
In light of the complexities surrounding inherited IRAs, it would be beneficial for individuals to consult with Rory O'Hara to ensure they are making informed decisions about their inherited assets.
