The Inherited IRA Time Bomb!

The Inherited IRA Time Bomb!

November 04, 2023

If your parents worked hard, saved and invested over the years, the idea of inheriting a $1 million IRA someday might be possible and sound nice. But are you really prepared to receive it and understand the tax implications? The SECURE Act of 2019 removed the ability for most non-spouse/non-charity beneficiaries to stretch the required inherited IRA distributions over a lifetime, and instead changed it to require all of the money to be withdrawn by the end of the 10th year after death (for deaths in 2020 or later). A SECURE Act update in 2023 clarified that annual distributions (RMDs) are required starting in 2024 from inherited IRAs. Not everyone started these annual RMDs back in 2020 because the law was unclear, and some interpreted it to mean that the full account balance just had to be withdrawn by the end of the 10th year. So now we know that annual withdrawals are required, and in this example, you have $1 million of income to fit into the next 10 years!

See the need for some serious tax planning? Tax planning is the process of projecting out your future income to determine strategies for how to pay the least amount of tax overall, either during your lifetime or a period of years.

Here’s an example with some additional details:

If your mom died in 2022 and left you a $1 million IRA (when you were 59), the first RMD year of ten years would be 2023, and the RMD amount on a $1 million balance (as of 12/31/2022) would be $36,900.37. This is just for year one.

This $36,900.37 would be taxed typically as ordinary income, which means it is added on top of your existing income! It could put you into a higher tax bracket or cause you to lose some valuable deductions or credits, so you need to be prepared. You may also need to withhold a significant amount of tax from the IRA withdrawal, in order to keep you from having a tax due when you file your taxes.

The table below shows the projections of RMDs for each of the ten years. All remaining funds are then required to be withdrawn in year ten. Assuming a 4% growth rate on the account, this would leave over $950,000 still in the IRA which would all need to be taken out and become taxable in year ten! Once the initial life expectancy factor of 27.1 was determined, you subtract one for each year that follows and divide it by the prior year IRA balance.

Income tax planning may reveal that it might make sense to take 1/10th of the account out each year (or more) to spread out the income, instead of just taking the minimum. Or another strategy could be to fully deplete the account before turning on other income sources such as a pension or Social Security, so your income tax bracket does not jump in future years. Clearly, tax planning is needed to make smart financial decisions about how much you should actually withdrawal each year based on your personal circumstances.