The New IRA Inheritance Rules: A Millennial Nightmare
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Think inheriting your parents' retirement account will be straightforward?
Think again.
The 2019 SECURE Act completely changed the game for inherited IRAs, forcing most beneficiaries to empty accounts within 10 years.
In this episode, I break down what these changes mean for Gen X, Millennial, and Gen Z inheritors, including the potential tax bomb waiting for you.
Learn why your parents' estate plan might be way outdated, and discover the crucial conversations you need to have now to protect your future inheritance.
Plus, get step-by-step guidance on navigating the complex world of beneficiary rules, RMDs, and tax planning.
🗓️ Schedule a FREE call to talk about whatever money questions are on your mind.
Transcript:
Hey, I'm Katherine. Thanks for joining me at Heir Necessities, the podcast that turns complex financial concepts into real talk for GenX, Millennial, and Gen Z inheritors.
I'm a CERTIFIED FINANCIAL PLANNER®, an investment advisor, and an inheritor, just like you.
Each week on the podcast, I'm breaking down a different topic related to generational wealth and inheritance.
Listen in to get the information you need as a current or future inheritor and learn how to manage your financial life yourself - not by asking Google what to do.
Understanding Inherited IRAs
Today on the podcast, we are covering everything inherited IRAs, the logistics of what to do after you inherit an IRA, everything you need to know about taxes on inherited IRAs, and how to plan for the withdrawals you're probably going to need to be taking from that inherited IRA for the next 10 years.
I'm also going to be covering how you should plan ahead if your parents are still living but you think you might inherit an IRA account. I've got the questions you need to ask and the planning that you need to do now so you don't get caught flat-footed when someone dies.inherit an IRA account
The Logistics of Inheriting an Inherited IRA
The logistics of what actually to do when you inherit an IRA or retirement account, an asset that passes by beneficiary designation. there are different ways that assets pass and the way that retirement accounts pass in most cases is that those accounts are gonna have a beneficiary designation on them.
So your parent might have listed you as the primary beneficiary, they die and then that account comes directly to you by contract. It doesn't have to pass through probate. It can be a very quick and easy process to go from your parent's account to your account.
Generally, all you'll need is a copy of the death certificate. You'll have to call the custodian where that original account, your parent's account is held, and then transfer it over to an account that you own.
Steps for Setting Up an Inherited IRA Account
So in order to do that, you basically need to do two things. The first thing you need to do is you need to set up an account that their IRA can transfer into. And so what you are going to be setting up in most cases is an inherited IRA account.
And that will require you to have your own information, but it will also require that you have information about the person who died. So you're going to need access to their death certificate to the details, birthday, social security number, date of death, all of that information in order to get that inherited IRA account open.
And then once that account is open, then you can go back and do what I alluded to before. You can call the custodian or the entity that is holding your parent's inherited IRA account. You give them the account details. You confirm that you're the person that this is going to. You kind of have to go through that validation and paperwork process. And then it should be relatively easy and can often get done in a matter of weeks to transfer that parent account into your own inherited IRA account.
Tax Implications of Inheriting an IRA
Logistically, it's actually a pretty easy process and it's one of the easier assets to inherit, again, just from a logistical standpoint in terms of moving assets from an account that whoever you inherited from owned to your own account. But once you've gotten through the easy part of that logistics, inherited IRAs actually become a much harder asset to inherit because of all the tax consequences that come along with those IRA accounts.
Let's start by diving into why inherited IRAs are a different asset to inherit than a taxable account or a house and some of the complexities with inherited IRA accounts. The first thing you need to know is the basics of what an IRA is. So an IRA is a pre-tax retirement account.
And for the purposes of most of today's episodes, we are talking about pre-tax retirement accounts. We're not talking about Roth accounts or post-tax accounts. And when I talk about a pre-tax IRA account, I'm also talking about something that applies if you inherit a 401k account. So it isn't actually exclusively those inherited IRA accounts. I am really talking today more generally about any inherited pre-tax retirement accounts. So that could be a 401k, a 457, whatever account it is.
Understanding Beneficiary Types for Inherited IRAs
The reason that these pre-tax inherited retirement accounts are different than other accounts is because there is a whole set of rules placed on them because of the tax advantages they have during someone's lifetime. Basically what the government has said is, okay, we're gonna give you all these tax advantages of these pre-tax retirement accounts during your lifetime, but we don't wanna give the same tax advantages to your heirs because we want to get paid the taxes that are owed to us to the government on this money.
And so in 2019, there was passage of something called the Secure Act, and it radically changed what happens to beneficiaries when they inherit an IRA account. So if you're listening to this, maybe one of your parents died and you inherited an IRA six or seven years ago. If you think another IRA might be coming to you in the future, then it's actually going to look very different than what happened to you when you inherited that first account.
And let's talk about how it looks like now. So the first thing you need to know about inheriting an IRA is that there are two different types of beneficiaries. There are what's called eligible beneficiaries and non eligible beneficiaries. And the rules about what you have to do with an inherited IRA are different depending on which camp you fall into.
So in that eligible beneficiary category, you have spouses of the deceased person, you have a beneficiary who's not more than 10 years younger than the deceased person, other exceptions. For example, if you're a beneficiary who's disabled, then you might fall into that eligible beneficiary category.
Rules for Non-Eligible Beneficiaries Inheriting an IRA
But because I work with Gen X, Millennial, and Gen Z inheritors, I am going to be talking in this video about the rules that apply to non eligible beneficiaries. And for the most part, all of my clients, if you're listening to this thinking about your parents and inheriting one of their IRAs, you are going to fall into that non eligible beneficiary class. And that means that the rules that you have about what to do when you inherit an IRA are not as favorable as they are to someone in that eligible beneficiary class.
Let's talk about what that means. The first thing that it means is that when you inherit a pre-tax IRA 401k retirement account, you are going to have to, again, as a non eligible beneficiary, fully empty that account within 10 years of the date of death of the person who died. And this can be varying levels of complex depending on how big that account is.
Let's assume that your parents saved, maybe they had an IRA or foreign K that had a ton of their employer stock in it that stock did really well. You've inherited a $4 million IRA. That's great. It's a huge privilege. It's incredible. And it's also a giant tax headache because over the next 10 years, you are going to need to fully empty that inherited IRA account. And that means withdrawing every dollar in that account.
Managing Tax Implications When Inheriting an IRA
And if you remember, if you think about those pre-tax IRAs, you put money into those accounts before you pay taxes on them. And then every dollar that you pull out of an IRA account is taxable income. Every dollar is taxable income. That's true if you're the person who created and funded that account. That's true if you inherited the account.
So you inherit this $4 million IRA and you know that you need to take withdrawals over the next 10 years. even if the money wasn't invested in all, if it was just in cash, you would still have $400,000 of additional income that you needed to be withdrawing from that IRA account every year.
And depending on where you live, depending on what your income already is, that could potentially be reduced by almost 50%. For example, if you already have a high income and you live in a state with a high income tax in Oregon or California.
Probably you're not going to keep that four million dollar IRA cash. It's more likely that you're going to be investing it. And so say the market does really well over the next 10 years. It's a good problem to have. But now maybe you're looking at pulling out and realizing 4.5 or 4.8 or even five million dollars in income taxes during a 10 year period. And that's something that really needs to be planned for and planned around because it may be just given the cadence of your life and what things are looking like.
It may be that there are years where it makes sense to take more withdrawals if the market's down, if you have a lower income year. It may be that you are planning to take a larger withdrawal in one year. Maybe you're looking to get a down payment, make a down payment on a house or purchase a house in cash, whatever it is. And so you're going to want to be actively planning for the tax consequences of inheriting that IRA.
Required Minimum Distributions for Inherited IRAs
The other piece that trips a lot of people up is that if the person you inherited the IRA from was already taking their required minimum distributions, so if they were over 73 and the IRS required them to take money out of that IRA every single year, you are going to be responsible for continuing those RMDs.
And it trips people up and it gets confusing because a lot of people think, okay, well, I know I need to fully empty this inherited IRA within that 10 year period. I'm gonna take equal or as equal as I can distributions over that 10 year period to try and spread out the tax hit. So I don't need to worry about the RMDs because I'm going to be withdrawing more than that amount each year, which may be true.
But then if you have a year where you don't take that distribution for whatever reason, you think, well, it's fine, I'll just make it up next year, and then you don't take that RMD, then there's a big penalty. And that penalty can be 25% of the RMD amount that you were supposed to take.
So it's a significant penalty that you are paying to the IRS and something that you are absolutely gonna want to watch out for. Those RMDs, they're not difficult to calculate the math behind them is complex, but there are a lot of online calculators that you can use so it's not particularly difficult to figure out what the RMD amount that you're required to take every year is the issue is more that you need to remember that it's something that you're supposed to do.
Planning Ahead Before Inheriting an IRA
If you're listening to this and you're like, okay, well, this is great information, but both of my parents are still alive or whoever I think I'm going to inherit from is still alive. Like, what does this mean for me? The thing that I want you to remember is all of these rules, especially having to take out the full IRA within a 10 year period are relatively new.
They were only enacted in 2020. And so it's possible, especially if your parents did their estate planning several years ago, that they're not even aware of this change. And they aren't aware of the tax consequences that their estate will have when it flows to you. So the first thing that I want you to do is to start educating your parents about exactly this issue and letting them know, just so you know, if I inherit a pre-tax IRA, this is what my taxes are gonna look like.
Say your parents live in like Florida, a state with really low taxes, but you make half a million dollars and you live in California. It could be that there are tax moves that your parents can make now that would significantly reduce the amount of taxes that you're gonna have to pay when you inherit, but it's likely that your parents aren't even aware of this because the change is so new and if they did their state documents 10, 15, 20 years ago it wouldn't have even been something that was on their radar.
I want you to educate yourself about this and spend some time understanding the tax consequences of inherited IRAs. Watching this video is a great start. I tons of other content about this on my blog, up on Instagram, and then start this conversation with your parents and it doesn't have to be like accusatory or even asking them to do anything.
It can just be as simple as, hey, did you know this? Did you know that if you have an IRA and I inherit it, I'm gonna have to pay taxes on all of it and I'm gonna have to withdraw it over a 10 year period? And if they say yes and you know, they're good with it, then that's fine. That's really all you can do. But if they didn't know and you have the kind of parents who are really excited about paying less taxes, it may be that there are some opportunities that they can bring to their financial advisor, to their estate planning attorney, to reduce the amount of taxes that you're going to have to pay when you inherit.
Contact Information
I hope you liked this quick and dirty overview of inherited IRAs. If you have any questions, I would love to hear them. You can always send me an email at katherine@sunnybranchwealth.com.
If you want to know more about Sunnybranch, you can check me out on Instagram @sunnybranchwealth. The podcast episodes are also up on YouTube. If you wanna check out more of the videos there, I'll have another one coming for you in another two weeks and I'll look forward to talking then.
Let’s take the next step together
Understanding how to manage and invest a current or future inheritance is not easy. Inheritors can encounter a wide variety of different situations requiring knowledge and finesse to manage. If you need more help, you can reach out to Katherine Fox, CFP® and CAP®, a financial planner for inheritors to learn how Sunnybranch can help you understand and plan for your future inheritance, whatever goals you’re trying to meet.
