Inheriting money is never a bad thing, right? Sometimes, the type of money you inherit can complicate the situation. For example, what happens when you inherit an entirely income taxable account and must withdraw the entire balance in 10 years?
This is what happens when you inherit a retirement account from someone other than your spouse, which is quite common. Think IRAs, 401(k)s, or any other tax-qualified account. Remember, taxes are owed on these accounts the previous owner has not paid, which becomes your responsibility.
As of 2018, a CPA Journal reported that 48.9 million households own IRAs with a total value of $5.4 trillion. Of these IRAs, 39 percent are owned by baby boomers, an aging population that will likely pass on these assets to their heirs, potentially you.
Traditionally, it was a relatively common estate planning practice to leave behind a non-spousal IRA or 401(k). The 2019 SECURE Act complicated this practice by eliminating the popular ‘Stretch IRA’ and enforcing the 10-year rule. The Act states that a non-spousal beneficiary must distribute the balance in entirety within ten years. The regulatory objective aims to pull forward tax revenue by requiring earlier distributions and making the transfer of wealth less tax efficient. There are instances of a ‘qualified beneficiary’ other than a spouse, such as a child or disabled adult- but we’ll assume a capable adult beneficiary.
The potential tax issue may be rather inconsequential if the balance of the IRA is relatively low or if the beneficiary enjoys a lower tax bracket. However, the net inheritance may be materially reduced if there is a large account balance or the inheritor is a high earner. Remember, distributions will be taxed at your highest marginal rate, which can create a serious tax puzzle and reduce the amount the beneficiary actually keeps.
So, the question is, how do you now distribute a non-Roth, non-spousal inherited IRA in the most tax-efficient way possible? The strategies are endless, but a few new ones have emerged, including waiting until retirement to start distributions if you expect to do so within the next ten years. Presuming you'll have a lower taxable income once you stop working, managing taxes on the distributions may become easier.
If you’re a younger beneficiary, anticipating any material pops or drops in income can create distribution opportunities. Of course, you can deny all planning and take the money in a sum as soon as you receive it or wait until the 10th and final year, but this is unlikely the best choice as it will likely result in the highest tax bill. Understanding where your tax brackets are today, and where they will be in the next 10 years should be considered.
In summary, if post-SECURE Act world, inheriting a retirement account requires more planning than just 'stretching' it out.
https://www.cpajournal.com/2018/06/13/untangling-the-inherited-ira-rules/