Inherited IRAs

The topic of inheritance is hopelessly conflicting.  On the one hand, you’re dealing with the loss of someone who loved you enough to leave you money, or loved you at least enough not to prevent you from getting their money when they died.  On the other hand, you’ve essentially been given a (mostly) tax-free gift.  

Grief aside, inheritance can be an outright gift for the FIRE investor, giving you a (possibly) unexpected boost toward early retirement.  It’s money that you likely didn’t account for that you now have the freedom to invest.  Dare I say that a good helping of people who actually accomplish FIRE before 50 got a helping hand from inheritance.

As anyone who’s ever dealt with this issue in real life will tell you, inherited assets come in many forms, be it cash in bank accounts, securities, physical assets, houses, etc., and it can take some time to sort through them and maintain them in the form you deem most prudent to keep.  I won’t talk about each of these specifically, but there is one form of inherited asset I want to hone in on, and that is an inherited IRA.  For this article, I’m talking only about an inherited traditional IRA, not a Roth IRA.

Inheriting an IRA means that your benefactor had money saved for retirement and didn’t burn all the way through it, evidencing at least some smart planning.  So if you inherit it from someone related to you, at least you have that in your genes.  Inherited IRAs also come with unique considerations that are worthy of discussion.

If you inherit an IRA, you might also see it referred to as a Decedent IRA.  A “decedent” is a legal term for a person who died.  The distinction is important, however, as to maintain a Decedent IRA, you’re required to have it titled in a very specific way; namely, it has to keep the name of the decedent in the account title or risk losing its special status.  Just make sure if you decide to move the brokerage firm holding the account that you open a new account as a Decedent or Inherited IRA.  Do not accidentally open a traditional IRA.  Once you specify that it’s an inherited IRA, the firm opening the account will be able to ensure it collects the proper information from you to open the account in the proper name.

Once you take over the Inherited IRA, it operates like any other IRA you might have.  You can buy and sell stocks in the account with no immediate tax consequences – that is, you won’t pay capital gains taxes every time you make a sale, nor will you be taxed when the equities in the account issue a dividend or the bonds in the account pay interest.

Action Items

One of the first things you’ll want to do after inheriting an IRA is to review the holdings in the account and determine whether they fit your investment profile.  Don’t assume that the person you inherited the account from had your same tolerance for risk.  This is especially true if you inherited the IRA from an older relative, who may have been holding money in less risky assets.  

The benefit of the IRA is that you can sell off everything in the account and completely re-adjust the investment holdings without any tax consequences – so long as you don’t take any cash distributions.  If your elder relative was holding nothing but municipal bonds earning 3% per year, and you’re 30 and looking to retire in 15 years, it’s probably time to cash those in and take a more equity-heavy approach.  Or whatever you want to do with it – remember, it has to fit your tastes and the risk you’re willing to assume.

Caution: Cash Distributions

Now – a point about cash distributions.  As I discussed above, an inherited IRA, like any IRA, grows tax-free, meaning there are no capital gains taxes.  But, you are taxed when you take money out of the account, and you pay those taxes as ordinary income.  So the taxes can be quite substantial, especially if you’re in your working years when your taxes are probably at their highest due to the fact that you’re earning a salary.

It might be tempting when you receive a pot of inheritance money to go a little wild.  Take some cash and get a bigger house or take a vacation or upgrade your car, or something like that – whatever it is people do.  And one option that you’ll hear when receiving an inherited IRA is that you can cash it out.  If you’re pursuing FIRE and have a bit of investment savvy, you’ll immediately recognize why this is a bad idea; but remember, not everyone will immediately recognize this, particularly if the concept of IRAs is unfamiliar.

So for those new to the topic, here’s why it’s a bad idea: liquidating the inherited IRA will be completely taxable to you as ordinary income.  And if the account has a decent sum in it, you’ll likely move up in tax brackets, increasing your marginal tax rate in the year in which you cash it out. 

The point is, liquidating an inherited IRA is probably not a good idea, as you’ll end up squandering a decent amount of the proceeds in taxes.  Unless you absolutely need the money, liquidating the account should be at the bottom of the list of things you do with it.   

It can really be tempting if you have some outstanding debt – imagine if you’re 25 with $100k in student loans outstanding and you inherit $100k.  You could be free!  But the cost of extracting that $100k (you’ll end paying likely at least 25% to 30% of that in taxes anyway) will cost you more than if you kept the loan, especially considering the investment potential for the money in the IRA.  

So before you think about taking cash, consider whether it’s a smart decision to do so.  There are bound to be some exceptions to what I’ve said above.  If you’re in college and have no other income, and you decide to cash out an inherited IRA worth $10k, you might not incur any taxes at all.  Yes, you’ll be foregoing a good early start on investing, but the above tax analysis won’t necessarily hold.  Like I said, you have to consider your individual situation.

Required Distributions

Assuming you decide to maintain the inherited IRA and invest – here’s the one major difference between an inherited IRA and a regular one that you set up: Required Minimum Distributions. Or, if you want to sound like you’re in the know, RMDs.

For a typical IRA, in the year in which you turn 72 (or 70 ½ if you turned 70 ½ before January 1, 2020), you’re required to start cash distributions from the account.  For years you’ve been able to let the money grow tax free, but the government won’t let you keep it in there forever, so now it’s time to start spending.  The amount you’re required to take out each year is called the RMD, and is calculated based on the year-end balance in the prior year and your life expectancy.  The brokerage firm holding your account will calculate the RMD for you, but basically it’s the amount that would draw down the account to a $0 balance in the year you’re expected to die.

How does this affect you as the beneficiary of an IRA?  Well, it depends on when the person who gave you the inherited IRA died and the person’s age when they died.  Note that the below is a very general overview and that there are a number of different circumstances that have to be taken into account – the administrator of the account (most likely the firm holding the money for you) will ask for all the information needed to determine whether and how much you need to take in distributions.  There is also different treatment if the decedent was your spouse; the below does not assume that you’re inheriting the IRA from a deceased spouse.  Also, there were some major changes to the RMD rules that took effect on January 1, 2020, so when you inherited the IRA will make a significant difference in how it’s treated.

Pre-January 1, 2020 IRAs

If the person died on or before December 31, 2019, you’ll have to start taking RMDs the year after the person died (and don’t forget to take the RMD, if required, for the decedent in the year they died).  However, the good thing is that you can set the distribution schedule to account for your own life expectancy, which can lower the amount you have to take each year if you were younger than the person who died.

So if the person who died was 75, their RMDs were assuming they would have a life expectancy of a few more years, meaning that each RMD was a fairly sizeable chunk of the account balance.  If you’re only 30, you can spread those distributions based on your life expectancy.  If that’s 81, then you can spread the balance over the next 51 years, which significantly reduces the yearly distribution.

If the decedent was under 70 ½ when they died, there’s an alternative to spreading RMDs over your life expectancy, known as the 5-year option.  Rather than taking RMDs each year, the 5 year option means you have to draw down the account by the fifth year after the decedent died.  In the interim, you don’t have to take any RMDs.  This option is not available if the decedent was over 70 ½ (or would have turned 70 ½ in the year they died).

Remember that you need to get the RMD correct.  The penalty for taking less than required is 50% of the difference between what you withdrew and what you were required to withdraw.  For example, if you take a distribution of $1,000, but the correct RMD would have been $5,000, the penalty would be a whopping $2,000 (50% of the $4,000 difference).  That’s quite the penalty!

Post-January 1, 2020 

If the person whose IRA you inherit died after December 31, 2019, the distribution requirements are a little less flexible.  Regardless of the age of the person who died, the beneficiary must wind down the account balance within 10 years.  You don’t need to take any particular amount in any particular year, but you do have to close out the account within 10 years.  It’s up to you to figure how best to do that to minimize your taxes.

There are exceptions to this if the person you inherit the IRA from was your spouse, if you have a qualified disability, if you’re a minor child, or if you were fewer than 10 years younger than the decedent.  Make sure you check all your options before you start incurring taxes.

Early Withdrawals

One final point about IRAs.  If you open an IRA for yourself, one trade-off in exchange for the fact that it can grow tax-free is that you have to commit to keeping the money in the IRA until the year in which you turn 59 ½.  If you make a withdrawal before then (though there are some exceptions), not only are you taxed on the distribution, but you’ll pay a 10% penalty.  

But, if you inherit an IRA, you can take the money out at any time without the 10% penalty.  You’re still taxed on the distribution, but you’re spared the extra 10%.  Of course, you’re still required to comply with the distribution rules above.

For the FIRE Investor

If you happen to inherit an IRA, it can certainly boost your investment balance, but there are few things you’ll want to do if you inherit one. 

First, make sure that you set it up in your own account.  This is particularly important if you’re not the only one inheriting the IRA.  If you have to divide the account with others (siblings, perhaps), you want to make sure you separate your share – especially because, for an IRA inherited before January 1, 2020, the RMD will be based on the age of the oldest beneficiary if you don’t put your money into a separate account.  Establishing your own account with the assets or cash in the account avoids any issues like this, ensures that the account is named properly, and gives you control over the trading.  And remember – as mentioned above – if you move the account to a new firm, make sure you tell them it’s a decedent IRA so that you set it up properly.

Next, review what you got.  If it doesn’t fit your investment strategy, change it.  One thing to be on the lookout for is if the person from whom you inherited the IRA used a money manager or advisor.  Once the account transfers to you, the advisor will likely try to keep you as a client.  It’s up to you to determine whether you want that, as an advisor might not be necessary depending on how you want to manage the account.  Also remember, particularly if the person who died was on the older side, that they may have been using someone who focuses on planning for seniors.  An advisor like that may not be well-suited to your own investment goals, especially if your goals involve a more equity-heavy portfolio that a FIRE investor might pursue (depending on your age).  

Consider whether you just want to move the funds to whatever brokerage you already use and manage them yourself.  Remember, it’s pretty easy to transfer securities – and in fact, the firm you’re transferring them to will do most of the work for you – you don’t even have to deal with the old firm. 

As you consider how to adjust the portfolio, consider whether and what RMD might apply to you.  First, determine whether you have to take the decedent’s RMD in the year in which you inherit the IRA.  If the deceased person was required to take one that year but didn’t do it yet, you might have to take their RMD.

Beyond that, consider whether the RMD or draw-down rule applies to you.  Post January 1, 2020, inherited IRAs definitely lost quite a bit of their favorable tax treatment.  If you inherited one prior to 2020, you’ve got a great opportunity to stretch out that IRA while enjoying the tax-free growth.  And one thing you can do with it, if you’re so inclined, is when you receive your RMD each year, have a good chunk of it go to taxes to offset any other investment-related taxes you’re incurring like dividends and capital gains (from other, non-retirement accounts).  It’s a good way to pay your taxes without having to dip either into your pocket or your salary.  

Or you can just let it ride.  Take that RMD (or what’s left of it) and reinvest it into your standard brokerage account.  (Quick note about that – depending on the property laws of your state, inheritance is generally treated as separate property, so consider whether you want to maintain that distinction if you’re married and reinvest the RMDs into a new account).

If you inherit a post-2020 IRA, consider the best way to draw down the account to minimize the taxes.  If you think your taxes will go up in the next 10 years (maybe some promotions are on the way), then consider whether to draw down more now.  But, if you’re say, 5-6 years away from reaching your early retirement, maybe you don’t withdraw anything until after you’re finished working, when your tax rate might be lower.  And again, you may benefit by re-investing the distributions in your standard post-tax brokerage account.  This way you keep the investment juices running toward your FIRE goal.

Regardless of the tax status of the IRA, inheriting one (and notwithstanding the death) gives you the opportunity to boost your investments.  As long as you make sure to check the investments, manage the distributions, and consider your taxes, an inherited IRA can certainly help put you on the path toward retirement.