Understanding the Benefits and Risks of Inherited IRAs

Inherited IRAs are a vital financial tool for individuals who inherit IRA or 401(k) assets. Although managing these accounts can seem challenging, understanding the benefits and risks is essential for making informed decisions.  This blog post aims to simplify the complexities of Inherited IRAs and offer a comprehensive guide for healthcare professionals.

An Inherited IRA is a retirement account opened in the beneficiary’s name to hold assets inherited from a deceased individual’s IRA or employer-sponsored retirement plan. The rules and requirements for managing Inherited IRAs differ significantly from traditional retirement accounts. It’s crucial for beneficiaries to understand these differences to reap the benefits and manage the risks effectively.

What is an Inherited IRA?

An Inherited IRA is set up for someone who inherits an IRA or an employer-sponsored retirement plan (like a 401(k)). After the account holder’s death, the beneficiary must take required minimum distributions (RMDs) from the Inherited IRA. The timeline and amount of these distributions depend on factors such as the age of the deceased and the relationship of the beneficiary to the deceased.

Impact of the SECURE Act of 2019

The SECURE Act, enacted in December 2019, brought significant changes to the rules for Inherited IRAs. One major change is the elimination of the “stretch IRA” for most non-spousal beneficiaries. Previously, beneficiaries could stretch out RMDs over their lifetime, allowing the funds to grow tax-deferred for many years. Under the new rules, non-spousal beneficiaries must withdraw all assets from the Inherited IRA within ten years of the original account holder’s death. This can have significant tax implications as larger distributions may need to be taken over a shorter period.

How it Differs from Other Accounts

• Traditional IRA: Allows the account holder to contribute pre-tax income towards investments that grow tax-deferred. Withdrawals during retirement are taxed as ordinary income.
• Roth IRA: Contributions are made with after-tax dollars, and qualified withdrawals are tax-free. There are no RMDs for the original account holder.
• 401(k): An employer-sponsored retirement plan permitting employees to save and invest part of their paycheck before taxes are taken out. Withdrawals during retirement are taxed as ordinary income.
• Inherited IRA: Requires the beneficiary to start taking taxable distributions. For non-spousal beneficiaries, the SECURE Act mandates that the entire balance be withdrawn within ten years.

Each type of account has its own rules for contributions, withdrawals, and tax implications, so it’s crucial for beneficiaries to understand these when managing an Inherited IRA.

Situations where Beneficiaries Might Need to Open an Inherited IRA

• Death of the Original Account Holder: When the original IRA owner or a participant in an employer-sponsored retirement plan dies, the beneficiary must decide what to do with the inherited assets. 
• Non-Spousal Beneficiaries: Non-spousal beneficiaries must open an Inherited IRA to take over the deceased’s account. They cannot roll the account over into their existing IRA.
• Spousal Beneficiaries: Spouses can transfer the assets into their own IRA or open an Inherited IRA. The choice depends on several factors, including the surviving spouse’s age and financial needs.
• Multiple Beneficiaries: When several beneficiaries inherit the account, they may each need to open a separate Inherited IRA for their portion of the assets. For example, three siblings inherit their mother’s IRA. Each one opens an Inherited IRA to manage their share of the inheritance individually.

Internal Processes and Mandates from Financial Institutions

Different financial institutions may have specific procedures and requirements for opening and managing Inherited IRAs. It’s essential to communicate with the custodian institution and understand their processes. These institutions might require certain forms, documentation, and adherence to their internal policies to facilitate the transfer into an Inherited IRA. 

Pros and Cons of Inherited IRAs

Inherited IRAs have distinct advantages and drawbacks. Understanding these can help beneficiaries manage the account effectively and align with their overall financial strategy.

Benefits

• Tax Deferral: Like traditional IRAs, Inherited IRAs allow for investments to grow tax-deferred. Beneficiaries do not owe taxes on the account earnings until they withdraw the money.
• Flexibility in Withdrawals: Depending on the beneficiary’s relationship to the deceased and age, they might have flexibility in when and how they take distributions.
• Avoids Probate: Assets transferred into an Inherited IRA typically bypass the probate process, allowing beneficiaries faster access to the funds. This can be particularly beneficial for those needing immediate access to the inherited assets for expenses like medical bills or mortgage payments.
• Growth Potential: Investing the inherited assets can lead to significant long-term growth, especially if managed aggressively and aligned with a long-term financial strategy.

Drawbacks

• Mandatory Distributions: Beneficiaries are required to take RMDs, which can have significant tax implications. The timing and size of these distributions depend on the beneficiary’s age and the deceased’s age at death.
• Limited Rollovers: Non-spousal beneficiaries cannot roll inherited assets into their IRAs, limiting their ability to consolidate accounts. This can result in multiple IRAs to manage, which can be cumbersome and confusing.
• Complex Rules: The rules governing Inherited IRAs can be intricate, leading to potential missteps if not managed carefully. Clear understanding and adhering to all requirements are crucial.
• Potential for Forgotten Funds: Over time, beneficiaries might lose track of these accounts, especially if they have multiple accounts or do not actively manage their finances. This can lead to unclaimed assets and lost potential growth.

Steps to Open and Manage an Inherited IRA

Opening and managing an Inherited IRA requires careful attention to detail and adherence to specific procedures. Here’s a step-by-step guide to help navigate this process.

1. Contact the Custodian Institution: Contact the financial institution managing the deceased’s IRA or retirement plan.
2. Provide Necessary Documentation: Typically, this includes a copy of the death certificate, verification of the beneficiary’s identity, and any required forms.
3. Open the Inherited IRA Account: Follow the institution’s process to establish the Inherited IRA. This might involve filling out paperwork specific to Inherited IRAs. The financial institution will guide the beneficiary through the necessary steps, ensuring all legal and procedural requirements are met. They have a financial incentive to keep the account with them. After setting up the Inherited IRA, you are able to set up a different Inherited IRA at your custodian of choice, and request a direct rollover.

Common Pitfalls and Mistakes

Avoid the following common mistakes when opening and managing an Inherited IRA:

• Missing RMD deadlines, resulting in penalties.
• Failing to update beneficiary designations, leading to legal complications.
• Overlooking the impact of distributions on overall tax liabilities.
• Ignoring investment options and leaving the assets in previous allocations.

Checklist for Managing an Inherited IRA

1. Contact the Custodian Institution: Get in touch with the financial institution holding the original account.
2. Submit Required Documentation: Ensure all necessary forms and documents are submitted.
3. Open the Inherited IRA: Follow the custodian institution’s process to establish the new account.
4. Request Asset Transfer: If needed, transfer assets to a different financial institution.
5. Understand RMD Requirements: Know the timeline and amounts for required distributions.
6. Consult with a Financial Advisor: Regularly review your strategy and adjust as needed.
7. Monitor Account Performance: Keep track of investments and rebalance the portfolio as necessary.
8. Stay Informed on Legal and Tax Changes: Keep up with any changes in laws or regulations that may affect your Inherited IRA.

Inherited IRAs can be a beneficial yet complex financial instrument. Understanding the benefits and risks, following the proper steps to open and manage the account, and employing strategic considerations can help beneficiaries make the most of their inheritance.