Inherited IRAs

I have been getting more questions on Inherited IRAs recently.  Inherited IRAs are a sad subject because death is involved.  It’s not easy to solve the inherited IRA dilemma while your friend is grieving, but it is a very important service.

While everyone appreciates an inheritance, managing that money is the last thing on your mind when you lose a loved one.  Inherited IRAs provide us with another example showing the importance of financial planning.

We know financial planning should start early in our adult life.  The money earned in our career should be managed by finding the balance between enjoying today and preparing for tomorrow.  When tomorrow comes, you have a plan on how to spend those saved resources over the remainder of your life.

Inherited IRAs can open a real can of worms in your family.

What happens to your resources if your life is cut short?  Everything just gets passed on to your loved ones, right?  You clearly defined your wishes in your will.  You filled out the beneficiary designation form on all of your accounts, so everything should be good to go, right?  Have you ever known our government to do things the easy way?  Yeah, NO!

I always find it funny when our lawmakers create little clauses in laws to help themselves.  The perfect, most recent, example was when Joe Biden promised to only tax the wealthy.  He promisedinherited IRAs that taxes would not increase for any American making $400,000 or less per year.  While that seems random, $400,000 is the president’s salary, so isn’t that nice and convenient?

The US Tax Code is extremely complicated.  Unfortunately, companies like TurboTax pay lobbyists to keep it that way.  You can’t blame them because a confusing tax code keeps them in business.  Like politicians, their personal well-being is their priority.  Complaining about that fact is pointless, but understanding it can be valuable.

It helps to understand that we are basically entering into a contract with the US Government when we create an IRA.

There are different rules for every type of account, so we will use the Traditional IRA for this example.  With a traditional IRA, we can currently put $6500 ($7500 if you are over 50) a year away for retirement.  Most of us can deduct that amount from our current taxable income, lowering our tax bill.  Don’t worry, Uncle Sam will get their cut later.

Again, it is helpful to think of the IRA as a contract.  The money in the IRA account grows and income taxes are deferred until you start taking money out of the account.  Your distributions are treated as income and taxes can be withheld just like in our paychecks.

While we are alive there are often tweaks to IRA rules, such as changing the age for required minimum distributions.  I think this is because we can vote while we are alive.  Of course, conspiracy theorists believe some votes are still counted after death, but that’s beyond the scope of this post.

I personally think Inherited IRA rules are so harsh because dead people cannot vote.

Politicians will look after their own interests first, regardless of what they say.  It is human nature to be a little selfish.  We all want to keep our job if we enjoy it regardless of whether we are a politician, a chef, or any other professional.

After our death, we no longer have our vote as leverage, so the politician wants to collect their money promised in your IRA contract.  To put it bluntly, you’re dead, so the politician sees no value in your opinion any longer.  It sounds awful and could be an overreaction on my part, but the laws speak for themselves.

There are ways to ease the tax burden on an Inherited IRA, but it’s safe to assume your beneficiary has ten years to empty the account.  Pretty harsh, right?  Honestly, that’s just the tip of theinherited IRAs iceberg, so please talk to me or another professional before doing anything.

It makes sense to use your IRA money first, so there won’t be an Inherited IRA.

In college we were taught to use IRA money first.  After learning about inherited IRAs, it makes perfect sense to me now.  Unfortunately, many of us will get this concept wrong because it goes against our very nature.

After being disciplined and putting money away for our entire life, it is hard for us to start spending the money.  Seriously, it has been said that one of the greatest challenges financial planners face is convincing the client to spend money.

And I just heard a collective groan from my clients because I am always preaching save, save, save!  This blog post is about the end of the financial journey, most of my clients are at the beginning of theirs.  Don’t worry, I’ll encourage you to spend eventually!

Personally, I think the reluctance to spend comes from the tax benefits on retirement accounts.

It’s fun to watch your savings grow without the government being able to touch it.  When you start taking distributions, the government gets their share as well, so many of us wait until we are forced to use that money.

After paying taxes their entire lives, some people just don’t want to give the government anymore, which is understandable.  Unfortunately, that attitude only hurts your beneficiaries.

By not touching the money in your IRA, your beneficiaries can be faced with a larger tax burden.  Their inheritance is treated as income, so your gift makes them climb the tax brackets.

If you don’t need the money in your IRA and plan to leave it to your children, I have an idea. You could transfer your distributions to a brokerage account.  Then you would pay the income taxes on the distributions, which honors the promise made to the government when you created the IRA.

However, the investment account should then be treated as an asset and transferred in the same way as a piece of land or a home.  Beneficiaries then get the benefit of a step up in cost basis.  This means that the assets are valued at your death and that value becomes the starting point for the beneficiary.  The cost basis is important because it determines profit if the asset is sold.

inherited IRAsLet’s use some numbers for an example.

Your IRA is worth $100,000.  If your child inherits this money as is, she may have to empty the account within 10 years.  To keep things simple, she takes everything in one distribution.  Let’s say the federal tax was 30% at that time, so she only keeps $70,000.

That’s definitely a nice gift, but what if we did things differently?  Over the years you start taking distributions, paying the taxes, and invest the remainder.  At the time of your death, your brokerage account is worth $100,000.

By the way, my fee is usually 1% of assets under management, so in this example paying me $1,000 could have given your child $30,000 more inheritance.  Sounds like a great deal to me!

This is what financial planners do.  Talking about stocks and expected returns is fun and gets all the attention, but our real value comes behind the scenes.  We look at the entire picture, do the research, and create ideas that maximize your resources.  It can be a tough and frustrating job, but I love it.  I would love the opportunity to help you as well.  Email me!

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Jonathan Greeson is located west of 117 and south of E. Main St.
Jonathan Greeson is located west of 117 and south of E. Main St.

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