Do You Actually Have an Inherited IRA?
May 1, 2022
Welcome to The Retirement Tax Podcast, where hosts Steven Jarvis, CPA, and Benjamin Brandt, CFP, work together to bridge the gap between tax professionals, financial advisors, and their mutual clients to help reduce most people’s largest expense in retirement: taxes. Each week, they will dive into conversations around taxes, focusing on what you can truly control (instead of what you cannot) and how to set yourself up financially for your future.
Inheriting an IRA is a situation that comes up with quite a few clients and, most likely, a situation that has or will happen to you. In this episode, Ben and Steven share some key insight into the complexities and must-know aspects of inheriting an IRA. They share the changes in how IRA inheritances work and highlight important ways that you can make it work out much more in your favor.
Listen in to hear about the distinction between inheriting an IRA and having an inherited IRA. You’ll learn the rules involved with this (and how things may have changed due to the Secure Act that came into play a few years ago), as well as how to potentially cut down your tax bill and make the best decisions on how to handle your inheritance.
What You’ll Learn In Today’s Episode:
Read The Transcript Below:
Steven Jarvis: Hello everyone. And welcome to the next episode of The Retirement Tax Podcast. I am one of your hosts, Steven Jarvis, CPA. And of course with me is the incredible Benjamin Brandt. Ben, how are ya?
Benjamin Brandt: Steven, I’m so happy to be here. I look forward to these times of first and 15th of every month. Always get excited about recording some new content with Steven.
Steven Jarvis: Yeah, it’s always a lot of fun. I get people who question on that all the time of, do you actually have fun talking about taxes? And honestly I do. There’s so many things in here that can have a real impact on people. And I’m naturally a competitive person. I like games. I like puzzles. I like problem solving. And so taxes really fits that for me because we can get in here and say, okay, what could we do a little bit different and make sure we come out ahead and make sure we’re winning this game?
Benjamin Brandt: And fun is an interesting word, right? Sometimes it’s fun where we can share a success story somewhere where that we help someone. And that’s fun. Sometimes it’s fun where we’re trying to read something specifically from the IRS and all of a sudden it feels like I’m reading Greek. And so the fun is that it’s like gallow’s humor, that we’re sharing in each other’s misery and laughing about it. So it’s different types of fun, but it’s always fun.
Steven Jarvis: For sure. Yes. If taxes went way tomorrow, I would still find other ways to have fun. I would not be lost.
Benjamin Brandt: Right. That’s true. That’s good. You got that going for you.
Steven Jarvis: Yeah. So today we want to talk about a situation that definitely comes up for I’m sure many of our listeners, it comes up with clients that you and I both work with, and that is inheriting an IRA. So this is you’ve been named as a beneficiary in someone else’s IRA and they pass away. Now you are of the owner of these funds. And really what we want to talk about is making a distinction between inheriting an IRA and having an inherited IRA, because there’s some pretty specific rules around this situation. And they’ve actually recently changed with the SECURE Act a couple of years ago. So maybe, Ben, why don’t you start by telling us what it used to look like when you inherit an IRA, and then we’ll jump into what we can do with it now.
Benjamin Brandt: Yeah. So it used to be like a nice escalator. You inherit a bunch of money from your grandparents or your parents, and you could just kind of take out a little bit every year. And you could just sort of keep that principle intact and it’d kick you out X amount of percent every year, depending on your life expectancy. It was a nice little escalator down. And that was called the stretch IRA, we essentially turned it into a pension and then we could keep the lump sum for our retirement. Just pay a little bit of taxes as you go. Now it’s really more like a cliff where you’ve got to take it all out. You get a little escalated, you get 10 little steps, but then it’s a big cliff at the bottom.
So we used to kind of be able to do lifetime payments. And then I could have my dad’s IRA as my IRA when I’m retirement age. Now it’s, you got to kind of pay taxes on it right now, potentially even before your retirement and then invest it or spend it or whatever you choose to do.
So kind of really big changes. The government has big bills to pay, which means we have big bills to pay. So things that we could have deferred that we don’t really need, and anytime you inherit money, I guess they figure you don’t really need it. That means you got to pay taxes on it quicker, which paying taxes on it quicker usually means you got to pay more in taxes. So that means we have to be more intentional than we would’ve been otherwise. Old laws, not to be very intentional at all, other than send the IRS some money every year. New laws, we’ve got to be super intentional or else we’re going to have a pretty significant haircut on that inheritance we received.
Steven Jarvis: Yeah. And the important date to keep in mind here is January 1st, 2020, that’s when the rule change took effect. So if you’re inheriting an account or inheriting an IRA after January 1st, 2020, what we’re going to talk about today is the rules that apply. And really for most people inheriting an IRA, we’re going to talk about this 10 year period, and you get 10 years from December 31st of the year that you inherited the IRA. So, that makes it a little bit nice. At least we don’t have to keep track of another birthday or anniversary. So we’ve got this 10 year period we’re going to talk about, but we also got to make some important distinctions on how these funds get treated. Because like so many things in life, there’s the default way that might just naturally happen if we’re not intentional, and that’s not the optimal way to approach it.
So what’ll happen in a lot of situations is that someone finds out they’re inheriting an IRA. And for real easy math, we’re going to talk about inheriting a million dollar IRA today. So, you find out you’ve inherited this money. And so what can happen sometimes is that people say, oh, great. I inherited this balance. Thank you, aunt Susie. Really appreciate it. Glad you remembered me. Great. Cut me the check. And then we’ll put in my accounts, we’ll figure out what to do with it. And already we’re running into problems because we’ve got to make sure that we’re following the rules along the way to keep that opportunity to even have the 10 years to do something about it.
Benjamin Brandt: Right. It’s a lot different than other lump sum payments you might receive in life. I get a tax refund. It’s $5,000. I can hammer that check today and I can go spend it, or I get some sort of dividend distribution, or I get a promotion at work, or I get some kind of a bonus. Right. That’s all happening this tax year. I can take that money and run. With an inheritance, you can take the money and run, but there are specific consequences based on that decision.
Steven Jarvis: Yeah. So we need to make sure that first and foremost, that these funds get put into an account that is an inherited IRA. It can’t get rolled over into another IRA that you already have. This needs to be a separate account specifically named for this purpose. So that we even have the option to use this over 10 years. If you need all the money today, great, take it, pay the taxes and move on. I mean, that’s certainly the simplest, but we’ll walk through the numbers here in just a second to explain for our listeners that there’s a potentially really large opportunity here. And like so many things, we can start at the high level or we can get incredibly nuanced, but we’ll just stay high level today just to show the potential impact.
And then it’s certainly something that you would want to evaluate in your own individual situation. So again, if we’re talking about a million dollar IRA, the simplest, the default would be let’s cash all out today. Let’s go ahead and spend it, and then we’ve got to pay taxes on all of it. So on a million dollars, making a lot of assumptions, but roughly you’re probably looking at $320,000 in taxes that you’re going to pay. A typical person’s going to pay assuming that there aren’t, you don’t already make another million dollars somewhere else. That’s if we pay it all in one year, and that’s not even including, if we’re on Medicare, what that would do to our Medicare premiums or other shadow taxes, other thresholds, we might get phased out of, that’s strictly the federal income tax.
If we just really simply spread that out over 10 years instead, and instead of taking the million dollars in income all at once, we’re taking a hundred thousand dollars in income each year over the next 10 years, even accounting for the tax rate that are going to go up in 2026, when the Tax Cuts and Jobs Act expires, we spread it over 10 years, we would pay closer to $240,000 taxes.
So that’s an $80,000 tax savings, which Ben and I like to talk about sanding off the rough edges of a tax bill. I mean, $80,000 sounds like some pretty diligent sanding.
Benjamin Brandt: Absolutely. That’s high grit sandpaper.
Steven Jarvis: Yeah. That’s very high grit sandpaper. And that’s, that’s just doing the very simplest approach of instead of taking it all at once, let’s spread it over 10 years. If we took it further and looked at other one time income or other thresholds, we could dial that in even further, but just at a very, very high level, we’re looking at potentially $80,000 in tax savings. So that’s why we’re talking about this. And that’s why I want to make sure that people understand that there’s some real value in having a plan and being intentional around this.
Benjamin Brandt: Right. So like with any big life change, you get a large inheritance, it’s a really great time to reach out to a qualified tax accountant, a qualified financial advisor, something like that, to get some guidance on what are my options, what are my goals, and how do those two fit together?
Steven Jarvis: Yeah. So even for our DIY listeners out there, this might be a good time to say, okay, even if it’s just this one year I work with a tax or financial professional, this is going to be a time that having that second set of eyes, even if it cost you several hundred or a few thousand dollars, we’re potentially talking about $80,000 in tax savings. To me, that seems like it’s well worth the investment.
Benjamin Brandt: Absolutely. Even just for the peace of mind, you’re not going to wake cup on a cold sweat two years from now, wondering if you made a mistake. Get somebody that knows what they’re doing. You’ll sleep better at night knowing so.
Steven Jarvis: Yeah. We make this point quite often but it’s because it’s very important, or kind of jokingly said that you could just take all the money and run you. You certainly can. Anytime you’re making these decisions, anytime these life events happen, please make sure you’re starting with what makes sense for your situation. If you have cashflow needs, if this is something that is going to have a real impact on your life, and hopefully it is, make sure you start there and you’re doing what you need to for your financial situation. And then we’re developing a tax plan that fits with that and helps us save taxes along the way. We want tax planning to be a passenger on the bus. We do not want tax planning to be the driver. So if that million dollars is going to change the course of your life by taking it all right now, don’t say, well, Ben’s and Steven told me I had to take it over 10 years. Taxes are a passenger.
Benjamin Brandt: Yeah. And I think that’s just being intentional too, that’s honoring the gift that someone gave you, right. They saved this money. That means that they told themselves no, in order to hopefully tell themselves yes sometime in the future, when they’re retired and they want to spend this money. Either through dying too soon, or living too long, or saving too well, they had the surplus that they left to you. So we can honor that gift by doing some intentional planning. So.
Steven Jarvis: Definitely if you’re in a situation where you have an IRA, hopefully you’ve named beneficiaries. This is also a good reminder to just make sure you’re intentional about your legacy planning and how you’re setting up your beneficiaries for success and what you communicate to them, so that they aren’t blindsided by a situation where they’re not sure what to do. And that they end up being in that position where they’re paying all the taxes all at once and not having a plan in place. Not that you necessarily need to share exact dollar amounts, but at least preparing your beneficiaries for, here’s what this might look like in the future. All right. So before we move into a listener question that actually is related to this topic, go figure. I pick out which ones we do each time. So there’s a little bias there.
Just want to remind all our listeners that if you would like to hear one of your questions featured on the podcast, feel free to go onto our website, retirementtaxpodcast.com/questions, and you can submit a question for us. You can type in a question. You can submit an audio question. We love to hear from our listeners, love to make sure that what we’re giving out, the topics we’re covering are relevant and helpful for all of you. So definitely encourage you to go out and send us a question, we will be more than happy to highlight it on the show. So the listener question for today says, I may inherit some IRA and brokerage after tax money. Since I have large pre-tax investments and no real cash currently in a brokerage to pay Roth conversion tax, is planning on using some inherited cash, a viable strategy? I’m 64 and retire at the end of the year, the inheritance could happen in the next few years. This feels a bit morbid to plan, but want to understand the issues.
Benjamin Brandt: It does feel a little bit morbid to plan. I hear that a lot. People want to generally plan with what their assets are and if I get anything, it’s a blessing, sort of attitude. I completely honor that. I totally respect that idea, but again, we want to honor the gift as well. So we don’t want to leave any money on the table. We want to pay. We owe no gratuity as we often say on the show. So we do want to think about it a little bit, especially as you are in your middle sixties, which means your parents might be in the middle eighties. We could definitely easily picture some situation where we wish we would’ve thought about it after the fact. So I would say, I think you’re really on to something listener.
You’re 64, I mean, when you’re doing your Roth conversions, you could simply withhold because you’re over 59 and a half, that won’t give you any issues at all. But if you really want to dial in those Roth conversions to their highest efficiency, some people do choose to pay those taxes outside of the Roth conversion. So what that would look like is, a $10,000 Roth conversion, if I’m withholding a thousand dollars, goes to the IRS, $9,000 goes into my Roth. If we want to crank up that sort of maximum efficiency, all of the $10,000 goes from my traditional IRA to my Roth, I’m paying the thousand dollars in income tax out of something else.
That something else could potentially be these brokerage accounts. If they’re titled properly and there’s no other asset taxes or any other issues, you’re probably going to get a step up in cost basis so that you can sell those accounts right away when you receive them after, this person that’s giving you these assets, after their death and potentially not owe any income taxes at all.
So that would be a really great opportunity to pre fund or to prepay some of these taxes with the hope that we’ll save a lot of money in the long term, and sand off some of those rough edges off of this big fat retirement tax bill we got to pay.
Steven Jarvis: Ben, I really like how you talk about honoring the gift. I think to this listener’s point, it can be a morbid topic. And a lot of times when we talk about financial planning, we get excited about the income piece of it. And we shy away from the kind of harsh realities of legacy planning. And we have all these other things we like to call it like legacy planning, instead of saying, hey, someday, I’m going to die. What happens? And I get it. I prefer to talk about it as legacy planning as well. But honoring the gift, honoring the work that’s gone into it, that’s a great way to think about this. Both in terms of planning for inheritances we might receive, as well as planning for anything we might leave to our own beneficiaries. There’s so much more of an impact we can have if we’re willing to have those uncomfortable conversations, make those uncomfortable decisions so that we’re maximizing those opportunities.
Benjamin Brandt: Yeah. It’s a difficult conversation to have. It borders on morbid and it borders inappropriate, right. You don’t talk about politics, sex, or money, right. Those are all sort of unpolite in kind of the old way of living, things we don’t talk about. But if we had a poll of everybody that’s going to leave someone else assets this year, I bet the vast majority would say, I’m hoping that they’re doing some planning to maximize this gift. If we polled everybody that’s receiving a gift, they would probably say, well, I don’t want to be morbid.
It reminds me of a conference that I was at once where the speaker said, show of hands, you’re driving to the conference today, and you see someone broke down on the side of the road. Show of hands, how many of you would help? Of course, every hand went up. And then he said, on the way to the conference today, your car broke down. How many of you are willing to ask for help? And nobody raised their hands. So everybody was willing to help, and nobody was willing to ask for help. I’m hearing a lot of that in this question, in that I don’t want to be morbid and things like that, but the person leaving you the gift probably wants you to have those conversations because they’re leaving you a gift because they care about you or they love you. And they want you to maximize that gift. So be willing to ask for help, be willing to ask some uncomfortable questions, honor boundaries, but honor the gift as well.
Steven Jarvis: Yeah, that’s a great analogy. And unfortunately, that really rings true for me of I’m much more willing to help other people than I am to step back and say, hey, I need help. So.
Benjamin Brandt: Sure.
Steven Jarvis: I’m sure that resonates with a lot of our listeners too. All right. So just recapping really quickly kind of the important points we covered today. If you are inheriting an IRA for most beneficiaries, that’s going to look like having 10 years to do something about it. Now something’s going to happen, whether you have a plan or not. So let’s take the time to have an intentional plan because the tax savings are potentially very impactful. So Ben, any other final thoughts on this topic before we close it out?
Benjamin Brandt: Yeah. You received an inheritance, it’s an amazing gift. Step one, high five your spouse, celebrate the life of this person that left you a gift. It’s great. They want you to celebrate. That’s why they left it to you. Step two, phone a friend. These are are big decisions. You should be willing to invest that time into making good decisions. So, and that’s what this show is all about. Making some good decisions so we can sand off the rough edges of our retirement tax, which is likely the biggest bill we’ll ever have to pay.
Steven Jarvis: Perfect. So with that recommendation until next time, remember to not let the tax man hit you where the good Lord split you.