If someone close to you (other than your spouse) has an IRA and you are named as the beneficiary, (sometimes called a “Stretch IRA), it’s important to understand the tax implications if they pass away. In this week’s MoneyDo, we explore the advantages and some of the rules around a non-spousal beneficiary, or “stretch” IRA.
A stretch IRA is a way to limit required distributions on an inherited IRA, avoiding a sizable tax bill in the process. Instead of naming his or her spouse as the IRA’s beneficiary, an account holder can name children, grandchildren or great-grandchildren.
Remember, in most cases money invested in a traditional IRA has never been taxed. Therefore, in those cases, all withdrawals will be realized as ordinary income – whether it’s the original account owner or you as the beneficiary.
For example, let’s assume you were fortunate enough to inherit a $300,000 traditional IRA from your brother Bob. When Bob dies, you have the option to withdraw the balance from the account and do as you please.
However, you just increased your income for that specific tax year by $300,000. If you’re married and already earned $100,000 from your job, you may pay around 24% – 32% Federal Income tax plus state income tax on the withdrawn amount and your regular earnings. If you’re a single filer the rate may be even higher.
Fortunately, for most inherited IRAs, there is a better way. In most cases, we suggest rolling your new-found wealth into a beneficiary, or stretch IRA, which allows distributions to be spread over your lifetime. The key here is that you roll into a new stretch IRA, not into an IRA you may already own.
Rolling into a beneficiary IRA has two distinct advantages: first, spreading distributions over your lifetime may reduce the effective tax rate on the distributions. Second, the balance will stay in the tax shelter, which will allow the balance to continue to grow, tax-deferred, similar to your other retirement accounts. Here are the specifics:
Account type:
- You transfer the assets into a beneficiary IRA in your name.
- If you were directly named a beneficiary you are able to calculate the required minimum distributions (RMD’s) over your life expectancy.
- If a trust was named a beneficiary of the IRA, and you are a beneficiary of the trust, you would calculate the RMD based on the age of the oldest beneficiary. You still may be able to move it into your own IRA but the distribution calculation may not be based on your age.
Money Availability:
- RMDs must begin no later than December 31st of the year following the death of the original account holder.
- This must continue and be recalculated each year until the balance is depleted.
- You will not incur a 10% early withdrawal penalty regardless of your age.
Note: If the original account holder did not take an RMD in the year of his or her death, their estate must take an RMD by December 31st in the year the account holder died.
We suggest consultation with a tax professional if you find yourself in this situation. While “stretching” the withdrawals from your beneficiary IRA is often the best course, sometimes another option might be better.
If the deceased was younger than 70.5 years old the five-year rule is also an option. This means you can choose to withdraw the funds at any time so long as the account is depleted within 5 years and still avoid the 10% penalty. This option might be beneficial if you find yourself in a low-income year (or years) where distributions can be managed and realized in a lower tax bracket.
