Why You Want To Spend Your IRA Money Before You Die

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Prior to 2020, passing wealth from generation to generation through an IRA was a viable strategy. A family could take a pot of money and grow it tax-free or tax-deferred, passing it down the family tree.

Now, to borrow from a Facebook relationship status option, it’s complicated.

The U.S. Senate passed the SECURE Act on Dec. 19, 2019. It includes a provision that prohibits stretching the distribution of an inherited IRA for an indefinite amount of time.

“You only give a traditional IRA to heirs you don’t like after this rule change,” money expert Clark Howard says. “You give them a traditional IRA, and the IRS is pounding them over the head with a sledgehammer every year.”

What did the rule change in terms of IRAs and inheritance? Are the rules different for a spouse? What are other, better vehicles to transfer wealth to your children or grandchildren? And will the IRS forgive you if you failed to adapt to the new rule in 2021 or 2022?


Table of Contents


How the SECURE Act Changed the IRA Inheritance Rules

If you’re the direct beneficiary of an IRA that belonged to someone who died prior to Jan. 1, 2020, you can still stretch out your withdrawals over your lifetime.

The rules were a bit more nuanced than that, but that was the basic framework. People even called it a “stretch” IRA.

Now, anyone who inherits an IRA must empty the account within 10 years.

There are some exceptions:

  • Surviving spouses (more on this later)
  • A beneficiary not more than 10 years younger than the deceased
  • Disabled and/or chronically ill beneficiaries
  • Minors (the 10-year clock starts when they reach the age of majority)
  • Those who inherited an IRA in 2020 or 2021 (temporary exception only)

With the exception of spouses, this group still has to initiate RMDs (Required Minimum Distributions) starting by Dec. 31 the year after the benefactor’s death. The IRS can penalize you 50 cents on every dollar you fail to take on time as an RMD.

There is a small silver lining: Because you’re forced to drain the accounts within a decade, the IRS won’t slap you with a 10% early withdrawal penalty for taking the money out before you turn 59½.

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(And for those of you asking: No, the rules don’t change whether or not the person died before or after their RMDs began.)

Naming an IRA Beneficiary: Individuals vs. Entities

If you want to avoid even harsher withdrawal rules, you must name an individual or individuals as designated beneficiaries of your IRA. That’s virtually the only way for your beneficiaries to stretch out their tax deferrals and withdrawals to the maximum.

If you leave your IRA to an estate, a trust (with exceptions), a charity, a corporation or any other entity other than an individual, the money has to be taken out (and any taxes paid) much sooner.


Missed Distributions: Forgiveness for 2021 and 2022

If you inherited an IRA in 2020 or 2021 but missed the rule change that passed as part of the SECURE Act, the IRS is extending you forgiveness.

That’s right: If you inherited an IRA after Dec. 31, 2019, you were supposed to take Required Minimum Distributions by the end of the next year.

For example, if your benefactor died in 2020, under the new rule, you were supposed to withdraw a certain amount of the money by Dec. 31, 2021. And if you failed to meet the deadline, the rule specifies you’d owe the IRS a 50% penalty on those dollars.

However, due to confusion with the rule change, the IRS has delayed the effective date of the new rule until Jan. 1, 2023.

In other words, anyone who inherited an IRA in 2020 or 2021 and missed taking their RMDs by the end of 2021 or 2022 will not have to pay a penalty.


Inheriting an IRA: Roth vs. Traditional

Clark loves all things Roth. He says tax rates are at historical lows now, and he expects taxes to rise in the future.

With a Roth, you contribute post-tax dollars. In other words, the money you contribute doesn’t reduce your taxable income. You are putting in money that the IRS has already taxed.

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So the IRS allows all your investments in a Roth 401(k) or IRA to grow tax-free and to be withdrawn tax-free.

If you’re not a surviving spouse and you inherit a Roth IRA, you don’t have to pay any taxes. But you still have to drain the account within 10 years. And you still must contend with RMDs unless you’re exempt (for example, a minor child).

If you inherit a traditional IRA, you’ll owe income tax on every dollar you withdraw.

A person can decide to convert their traditional IRA into a Roth IRA while they’re living. though that can lead to a substantial one-time tax bill on 100% of the funds. Instead, you can spread out that conversion over many years.

Any money you convert from a traditional to a Roth IRA is money that your future beneficiary won’t have to pay taxes on when he or she makes a withdrawal.


Why IRAs Make for Less Than Ideal Inheritance Gifts

Within the last two years, I’ve written about almost every nuance of retirement accounts such as IRAs and 401(k) accounts including back-door Roth IRAs, spousal IRAs, RMDs and more.

However, the rules around inherited IRAs are by far the most complicated that I’ve come across. It’s almost impossible to state every caveat, exception and nuance of the rules surrounding inherited IRAs and the rules and requirements around withdrawals.

But here’s one you should keep in mind: If you aren’t a spouse and you inherit an IRA, you must set up a new account with a specific title that conforms to tax law. Don’t put the account in your own name.

Going back to the beginning of the article, Clark mentioned that the IRS hits IRA inheritors over the head with a tax “sledgehammer” each year. You have to withdraw the full amount in the IRA you inherited within 10 years. And when you’re withdrawing from a traditional IRA, the IRS considers every dollar as taxable income.

If you’re still working, that extra income can push you into a higher tax bracket.

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Also, it can get awfully complicated trying to divide funds equally if they’re split among Roth and traditional IRAs.

For example, you can try to leave the traditional IRA funds to the person in the lowest tax bracket. But it’s challenging to predict what the tax brackets of the beneficiaries will be years in the future. If there are multiple beneficiaries, they can also split the IRA into multiple accounts by Dec. 31 the year following the benefactor’s death.

That’s one of the reasons Clark says, only somewhat in jest, that you only leave IRAs to heirs you dislike.

There are much simpler, less tax-punitive ways to leave wealth to your relatives. They include:

  • Real estate (including houses)
  • Stocks, mutual funds and ETFs held in a taxable brokerage account
  • Trust funds

What Are the Rules When a Spouse Inherits an IRA?

If you inherit an IRA as a surviving spouse, you at least have options, though they’re perhaps even more complex than if you’re a non-spouse.

You essentially have three choices:

  1. Treat the IRA as your own and become the account owner. This can be a good option if you’re younger than your deceased spouse.
  2. Roll over (transfer) the funds into your own IRA. You have 60 days to execute this transfer. This creates a “fresh start” IRA. You can delay the withdrawals until you’re 72 years old when your RMDs kick in. Keep in mind you can also split the funds in the IRA you inherited between the first option and this one.
  3. Treat yourself as the account beneficiary. This can be the best option if you were born well before your deceased spouse.

Depending on which option you choose, the timeline is not your friend. Although two months is a decent amount of time, you may well have other things on your mind when mourning a spouse.

If you don’t have a financial advisor, consider the Garrett Planning Network. Enter your ZIP code and you’ll get a list of fee-only fiduciaries near you.

Garrett’s member advisors are required to be accessible, meaning they can’t reject clients based on income or assets. They provide financial planning and investment advice on an hourly, as-needed basis.


Final Thoughts

Confused yet? If you’ve made it this far, I commend you. This is complex stuff.

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Let’s recap from a zoomed-out vantage point.

If you’re lucky enough to have amassed wealth across multiple pots, including a house, retirement funds, savings and stocks, congratulations. You have options.

Consider withdrawing and spending the funds in your IRA first. Your beneficiaries probably would rather inherit the other stuff, whether or not they know it yet.

However, getting any inheritance at all is not a given. It’s a major plus to leave any substantial amount of money to a child or family member even if it’s attached to complicated IRA rules.

Just make sure you specify a person (or multiple people) as the beneficiary of your IRA to make sure they have as many options as possible.

Questions about IRAs or other money topics? Call Team Clark’s free Consumer Action Center. An experienced volunteer can help: 636-492-5275.


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