Uncle Mortimer has recently died, leaving your twin sister his $300,000 record collection and you his $300,000 Roth IRA.(1)
Continue Reading Below
Your sister Hazel is overjoyed and can’t wait to sell those old 78s so she can buy that new house she’s been eyeing. You, on the other hand, are kind of bummed out. After all, Uncle Mortie had always insisted you were his favorite. An IRA? What are you supposed to do with that?
Fortunately, you work with an experienced financial advisor who sets you straight: though the dollar amounts are identical, the IRA your uncle left you is potentially much more valuable than the records--but only if you handle it correctly. In fact, while Hazel’s new home will likely turn into a money pit, your inherited IRA could provide a comfortable income for the rest of your retirement.
As your advisor explains, after Hazel finds a buyer for the record collection (purchased decades ago for next to nothing), she will immediately lose 45% to income tax. That will leave her with $165,000. Not exactly the bonanza she envisioned.
What if Hazel didn’t buy the new house and instead invested the proceeds? Let’s assume her account earned 6% and that after paying taxes, she’d end up with a net return of 4.5%. If she left all the money in the account for 21 years, it would grow to $415,840.
On the other hand, the money you receive from your uncle’s Roth IRA is tax-free. If you cash it in, you’ll walk away with the full $300,000. If you chose the same investment as your sister and left it alone for 21 years, your $300,000 would grow to $756,072.
Continue Reading Below
But there’s a smarter approach: Use the same investment, but leave the money in Uncle Mortimer’s Roth IRA and withdraw a certain amount each year. Not only is your withdrawal tax-free, the money that remains invested inside the Roth IRA also continues to grow tax-free.
As a 65-year old, the IRS gives you 21 years to empty Uncle Mortimer’s IRA account. You simply have to withdraw a minimum amount each year- called your “Required Minimum Distribution” (RMD). This strategy is called “stretching” an inherited IRA. And it can turn a relatively modest inheritance into a lifetime of income. In this example, by just taking out the minimum required over 21 years, Uncle Mortie’s Roth IRA will end up paying you with $875,135 in income.
The only problem with the above scenario is that, according to Certified Public Accountant Mike Jones, “It’s very difficult to find a competent advisor in this area. That includes tax as well as investment professionals. The most powerful thing to do is self-educate and work with an advisor… Discuss how this inherited IRA will fit into your life." For instance, while stretching out the distributions from the IRA will maximize the tax-deferral it provides, this might not be the best decision for your particular situation. As Jones says, “Maybe you have credit card debt that you would benefit from paying off.”
As someone who writes and speaks about IRAs, Jones has heard horror stories about what can happen when an uninformed or confused individual makes an innocent/stupid mistake. The biggest one, he says, is not filling out the beneficiary form for an IRA. In some cases, the contract with the IRA custodian states that the default beneficiary is your estate. In that case, your account must be liquidated- and taxes paid- in five years. Your beneficiary gets no stretch-out, no more tax-favored growth.
Another common mistake, according to Jones, is also something that is easily avoidable: “Never fill out IRA forms online.” It’s too easy to click the wrong box and press "submit.” Instead, he recommends printing out the form and filling it out the old-fashioned way, i.e. by hand. In his view, “We are more careful reading what’s on paper. It also gives you an important opportunity to review” the choices you’ve made.
The top mistake made by IRA inheritors? The knee-jerk reaction of, “Oh, goodie! Here’s my new car!” Which leads to immediately cashing out the account. Not only does this tend to push you into a higher tax bracket, as Jones points out, “You deprive yourself of the ability to invest Uncle Sam’s dollars and make money on those dollars.”
Lastly, make sure your financial advisor knows the details of your IRA agreement. “This is an estate planning document, says Jones. “Your advisors should be aware of it.”
Note: Recently the U.S. Supreme Court ruled that inherited IRAs are not protected if you file for bankruptcy. Read more about here.
1. Inheritance tax was paid using other assets in Uncle Mortimer’s estate.