Inheriting an IRA is bittersweet. In the midst of grief, you suddenly have to bear the weight of new financial responsibility. It's important to have a firm grasp over how these accounts work as well as what you have to do to manage your inheritance as a beneficiary IRA owner.
Spouses of a deceased IRA holder have the simple option of rolling the inherited IRA into an IRA in their own name. However, non-spouse beneficiaries have to deal with a more limited set of choices.
Below, you'll find four key ways to manage and allocate an inherited IRA.
1. Take it in context
When you inherit a tax-deferred IRA, you should consider the investments held within as part of your entire financial picture. Even though the account you inherited represents the retirement savings of someone else, it's now part of your world.
Too often a beneficiary will ask how to invest their inherited IRA, and the only true answer to this is: “within the context of your total financial picture.” Make sure to view it as one of the accounts you own and not an entity unto itself.
2. Use it to fund your own retirement plans
This is a useful trick for those who may be falling short of maximizing contributions to their own workplace retirement plans like a 401(k) or 403(b).
Beneficiaries must take required minimum distributions from their inherited IRAs if the original account owner was taking them at their time of death. Every dollar removed from your inherited IRA (whether it's part of an RMD or not) will be taxed at your marginal tax rate.
If you were to divert the money removed from your inherited IRA to your workplace retirement plan, you'd be effectively canceling out the income caused by the required distribution.
For example, say your RMD for one year was $3,500. This would increase your taxable income for the year by the same amount. But let's also imagine you divert the money to your own retirement plan at work, and you receive a tax deduction of the same amount.
In effect, you remove the RMD from your taxable income today and set the money to grow decades into the future — a winning combination.
What's more: Your workplace retirement plan doesn't require any distributions until you turn 72, so you'll give your money a chance to compound tax-deferred without any disruption.
3. Hold income-producing investments
It's important to remember that the rules surrounding asset location still matter a lot here. Asset location, simply put, refers to placing investments in certain accounts to maximize their tax efficiency.
Stock index funds are often best held in tax-exempt accounts, like a Roth IRA, or in a standard taxable brokerage account. This allows you to take advantage of preferable long-term capital gains tax rates as stocks rise.
An inherited traditional IRA is a tax-deferred account that is best suited to holding investments that derive most of their value from income. This means holding investments like bonds and real estate investment trusts in your inherited IRA will help to minimize your taxable income in any given year.
4. Stretch it out if you can
If you inherited an IRA in 2019 or earlier, then you have the opportunity to keep the IRA as long as it still has money in it. If you're a young beneficiary, that could be for many decades.
However, newer tax laws have effectively eliminated the so-called “stretch IRA” for many beneficiaries of newly inherited IRAs. Nevertheless, the new laws allow for a 10-year period before you have to take out the money, giving you at least a limited stretch opportunity. Moreover, there are some exceptions to the new rule for minor children and for those not more than 10 years younger than the deceased person.
Not as hard as it looks
Inheriting an IRA can open up many opportunities for the average saver. It can also add some personal meaning to your financial plan if you had a strong connection with the person from whom you've inherited the money.
Learning how inherited IRAs work is in many ways a sign of respect to the decedent in that you're handling their money with prudence; additionally, making the most of any windfall amount will allow you to get your own financial house in order.
Inherited IRAs come with a few unusual wrinkles, but in many respects operate the same as any other IRA. Be confident that you can learn the basics around these accounts and treat the money as if it's your own — because it is.
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