TRUST & ESTATE PLANNING

Inheriting an IRA: When Should You Take Distributions Under the New Rules?

02.17.2021 - Bryan Kirk, Director of Estate and Financial Planning and Trust Counsel

Starting in 2020, new rules apply when you inherit an IRA. Unless you inherited the IRA from your spouse or meet other special criteria, you no longer have the option to stretch distributions from the IRA over your lifetime. Instead, you’ll generally be required to withdraw everything from the IRA within 10 years.

This new rule limits the benefit of continued tax-free growth within the IRA. It also presents non-spouse beneficiaries with an important new question: When should you take your distributions during the 10-year period?

First, Answer These Important Questions

To make an informed decision on when to take distributions, you’ll need to answer several critical questions:

  • Does the 10-year rule apply to you?
    The IRA rules are complicated, so don’t make assumptions. As mentioned, the 10-year rule doesn’t apply to spouses. It also doesn’t apply to minor children or chronically ill or disabled individuals. If the IRA beneficiary is a trust, the 10-year rule may or may not apply depending on the terms of the trust. Work with your tax and legal counsel to confirm the distribution timeline that applies to your situation.
  • What are your goals?
    What do you want to do with the IRA? If your goals are longer term, you typically will have more flexibility to delay withdrawals and potentially to reduce taxes on your distributions. If your goals are shorter term, like buying a home or remodeling in the next year, you may be willing to sacrifice potential tax savings to have access to funds when you need them.
  • Will your tax bracket change?
    With a traditional IRA, the question of when to take distributions is about timing it for years when your tax liability will be less. As a result, it’s important to know your current tax bracket and understand why you’re in it. You should identify any potential changes that might lie ahead for your income level or deductions. For example, consider whether you may make any significant charitable gifts in upcoming years.
  • What is your investment strategy?
    The benefit of tax-free growth in the IRA depends largely on how its assets are invested. You should review your overall investment plan and determine how the IRA will fit into your strategy.

In addition to answering these questions, take stock of the potential unknowns. These might include life events like marriage, divorce, early retirement, late un-retirement, or the birth of additional tax credits (i.e., children). Also keep in mind that tax rules are not set in stone, so your assumptions about future taxes could change.

Second, Bring Your Answers Together

In some cases, going through the four questions above will make the best strategy for you clear. In other cases, it may make it clear that you need to take a more detailed look at the numbers.

For example, let’s say you’ve inherited your mother’s $2 million traditional IRA. You are single and earning $400,000 a year as an executive living in Florida where there isn’t a state income tax. You already have your own $2 million retirement account and a $1 million investment account, and you plan to save these assets and what you inherit for retirement, which is still over 15 years away.

Under these circumstances, it most likely makes sense to defer withdrawals from the IRA until year 10 and take a single lump-sum distribution at the end of the period. Why? As a single person consistently earning $400,000 a year, you’re already in the 35% federal tax bracket. Taking the distribution in year 10 will push you into the 37% tax bracket that year under current rules. But given you’re already in a high tax bracket, there’s not an opportunity to take distributions in an earlier year at a much lower rate. In addition, by keeping assets in the IRA, you can benefit from the tax-free growth for the full 10-year period.  

But now let’s change our assumptions and say you’re already retired. Instead of earning $400,000 a year, your income is only based on earnings from your taxable investments. You’ll also have Social Security and distributions from your existing retirement account eventually, but that won’t be until at least 10 years if you can make it work.

In this situation, it will likely make sense to withdraw funds from the IRA evenly over the 10-year period. Why? By taking out an equal amount each year, you can take the biggest advantage of your lower tax bracket. If you were to take everything out of the IRA at once, the bulk of it would be taxed at the highest federal rate of 37%, as mentioned above. By spreading it out, the bulk of the distributions would be taxed at much lower rates, which can easily make up for any sacrifice of tax-free growth. It also may align with your short-term goals by providing a source of funds without depleting your other accounts or needing to realize capital gains in your taxable investment account.

Of course, these are only two simple examples. If you expected your income to increase significantly in future years, taking an immediate lump-sum distribution especially if your income level has a low year, can be the best strategy. Or if your income is lumpy, you may want to play it year-by-year. If you are a high earner, you could plan to defer until the tenth year but accelerate distributions if your income is down for a year or you decide to make a large charitable gift. Alternatively, if your income is more modest, you could plan to take an even amount each year, then defer distributions if you receive an outsized bonus or other income one year.

Make an Informed Decision

If you have inherited an IRA, we can help you decide on the best distribution strategy for you. At Fiduciary Trust, we know each situation is unique and the variables may change from year to year. Our Wealth Planners can help you find a distribution strategy that aligns with your goals, minimizes taxes, and offers benefits for generations to come.

For details, contact your Fiduciary Trust representative or call us at (877) 384-1111.

This communication is intended solely to provide general information. The information and opinions may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

 

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