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Taxes and Retirement - Part 4

Taxes and Retirement - Part 4

| February 28, 2024

This week we’re wrapping up our discussion of taxes in retirement with a look at one way to protect your heirs from tax implications when it comes to your IRA. 

When planning your retirement, it is easy to focus solely on creating resources to replace the income of your working years. However, there is another very important component to retirement planning, and that is paying close attention to the tax treatment of your retirement assets for your heirs. It is for this reason, that I approach retirement planning from a combined perspective that includes not only retirement planning but also estate and tax planning. Let’s talk about that a little bit more.

The reason I approach retirement planning with this combined perspective is that it helps to avoid loose ends. For example, most people think that your will covers the distribution of all your assets. They don’t realize that an IRA is one asset and EVERYTHING ELSE is another asset. This is because things like a trust or a living trust only cover non-IRA assets, while IRA assets are governed by the beneficiary form, which overrides all other instructions you may have. 

This means, that it is critically important to make sure the beneficiary elections on your IRAs are done properly; and to do that, you need to think about the present and future state of your IRA. In other words, who has it now, and who will have it in the future. 

What does this mean? Let’s take a look.

What this means is that when it comes to IRA distributions, there is no reduction in capital gains taxes. The assets in the IRA will be taxable to your heirs after you pass and they will be subject to federal income tax, federal estate tax, and depending on your state of residence, state income, and state inheritance tax. This is what I call the “IRA Problem” which means that hypothetically, up to 75% of the IRA assets you leave to your heir may be subject to taxes. 

This often happens because people don’t understand the difference between an Inherited IRA and an IRA they inherited.

Let’s take a look at ways to manage those potential tax implications. 

I want to start by talking about the inherited IRA. 

What is an inherited IRA?

Ideally, you’ll want to have a conversation with your intended heirs about what an inherited IRA is before you pass. This is because an inherited IRA is an account that MUST be opened when an individual inherits an IRA or employer-sponsored retirement plan after the original owner dies. In other words, only your beneficiary or heir can open it and only after you pass. The individual inheriting the Individual Retirement Account (IRA) (the beneficiary) may be anyone—a spouse, relative, or unrelated party or entity (estate or trust).1 But keep in mind, rules on how to handle an inherited IRA differ for spouses and non-spouses, and for today’s purposes, I am speaking only about non-spouse beneficiaries. Tax laws surrounding inherited IRAs can be complicated, and they became even more so with the SECURE Act of 2019, which made some significant changes to the regulations—mainly for heirs other than spouses so it is important to talk not only with your beneficiaries, but your accountant, about this as well.

How does it work?

So how does it work? After you pass, your heir will establish an inherited IRA that will accept the transfer of funds from the IRA you left them. This makes the transfer far more simple and efficient. As we said, it is very important to note that the only person that can establish an inherited IRA is the beneficiary and it can only be done after your passing. This type of IRA is primarily used by non-spouse beneficiaries.

There are several benefits to establishing an Inherited IRA starting with the fact that your heir will not be subject to income tax on the inherited assets all in the year received. 

Another positive is that there are no Required Minimum Distributions (RMD) until the end of the 10th year, however, the funds must be withdrawn from the account by the 10th year. This allows heirs to defer income taxes for at least 10 years. 

Now, I understand this is a complicated subject and we’ve only scratched the surface on it here, so I encourage you to reach out to discuss this and the other tax issues that may affect you or or heirs in retirement and beyond. 

I also encourage you to join me for my March blogs in which we will review some of the building blocks of sound investing.

Until next time…

One last thought: we believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share.


Sources:

Inherited IRA: Definition and Tax Rules for Spouses and Non-Spouses

Internal Revenue Service. "Retirement Topics - Beneficiary." Accessed January 21, 2024.

This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice. Please consult your tax professional for your specific situation