Forbes Councils Member
COUNCIL POST| Membership (fee-based)
Rory O’Hara, CFP®, CRPC®, is the founder and senior managing partner at Ausperity Private Wealth.
Many adults will, at one point, inherit an IRA. Most, however, lack a basic understanding of the rules and potential tax ramifications associated with assuming control of such an account. That’s hardly a surprise.
For one, the topic is steeped in minutia, involving complexities that even many financial advisors fail to understand fully. Another issue is that it’s linked with death, which is an unpleasant reality of life, often causing some to keep anything related to it at arm’s length. (This also explains why many people don’t have a will or an estate plan.)
Overall, everyone needs to understand the potential consequences if an inherited IRA gets liquidated too quickly (taxes!), along with the fallout if it doesn’t happen soon enough (penalties!). But there are some other intricacies to keep in mind, too. Here is what to look for and how to avoid potential pitfalls with inherited IRAs.
Traditional Versus Roth IRAs
Most people appreciate that traditional and Roth IRAs are taxed differently. But as a reminder, the latter consists of after-tax assets, which can accumulate in value and are not taxable upon withdrawal. Meanwhile, the former gets funded with pre-tax dollars. Those also accumulate in value but come with a variety of tax obligations.
These rules generally apply to inherited IRAs as well. For non-spousal beneficiaries, it’s pretty simple if you inherit a Roth: You have 10 years from the original owner’s death to liquidate the account. There are no required minimum distributions (RMDs), and, again, that money is tax-free.
However, if you inherit a traditional IRA, things are more nuanced. The key question is whether the account owner was taking RMDs.
If so, you also must take RMDs (based on your life expectancy) and liquidate the account within a 10-year window. If the original owner of the traditional IRA was not taking RMDs when they died, you don’t have to take them either—but the 10-year rule still applies.
(Note: Spousal beneficiaries can roll an inherited traditional IRA into their own preexisting traditional IRA, thus potentially delaying RMDs. Also, it’s possible to roll an inherited Roth IRA into their own preexisting Roth IRA, which would allow them to avoid the 10-year rule.)
Investment Decisions
The disparate tax treatment outlined above may also color how heirs invest within their inherited accounts. In general, a Roth IRA offers the opportunity to be more creative, while a traditional IRA calls for some caution.
For example, let’s say an heir who is relatively young and financially secure inherits a Roth IRA from a parent. They could add some growth-oriented holdings, allow the entire balance to accrue for 10 years and then withdraw everything tax-free.
On the other hand, since traditional IRA withdrawals are taxable, a more conservative, balanced approach typically makes more sense. Moreover, it’s probably a good idea for most heirs to draw down the balance annually (even if they aren’t subject to RMDs). Otherwise, they could be on the hook for an outsized tax hit at the end of the mandatory 10-year liquidation period.
Generational Planning
IRA owners don’t have to give IRA assets to their heirs directly. Notably, many high-net-worth investors make a trust the beneficiary, an avenue that provides them with greater control over how the assets are managed—which can give them peace of mind.
Via a trust, it’s possible to impose limits on when and how proceeds from an account get distributed (hopefully in a tax-efficient manner). In some instances, this approach will give heirs time to develop the patience, knowledge and humility to handle a sudden influx of cash responsibly.
Even without a trust, heirs can benefit from adopting a trust-like mindset—viewing the inherited funds as a long-term resource rather than a prize they can spend profligately. This perspective can help avoid mistakes stemming from poor tax planning or impulsive financial decisions.
Indeed, most financial advisors will tell you that people are far more cautious with the money they have earned and saved than a windfall they’ve inherited. It’s partly why generational wealth can be hard to preserve.
Professional Guidance
When it comes to inherited IRAs, one size rarely fits all. Professional financial advice is invaluable given the assorted number of tax rules, timelines and investment strategies. Working with a knowledgeable advisor helps ensure you make decisions tailored to your specific needs and goals—preserving and growing the wealth entrusted to you.
The bottom line? Don’t go at it alone. The right guidance can make all the difference in turning inherited assets into a meaningful legacy.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
