When his 75-year-old father died, forty-year-old John inherited his father’s $1 million traditional Individual Retirement Account (IRA). John wasn’t sure what to do with all that money. So, he contacted the financial institution managing his father’s IRA and asked them to send him a check for the full amount. He figured that once he got the money, he’d put it in his savings account and give himself a little time to decide what he would ultimately do. After all, he knew that with his own traditional IRA he could take the money and roll it into another IRA within 60 days without penalty.
But that’s not the way it works with inherited IRAs. Unfortunately, John didn’t wait to find out the rules. And so, because he received that lump sum distribution, he lost out on the opportunity to stretch out the growth and tax benefits of that money over years, possibly decades! Instead, the $1 million was included as income the year he received it, placing him in the highest tax bracket! With a combined Federal and NJ state marginal income tax rate of 45%, John paid $450,000 in taxes on that $1 million distribution!
So let’s examine this:
– As noted above, John requested the lump sum payout before he knew what rules applied to his inherited IRA. He should not have done this!
– Under the IRA beneficiary rules, John could not roll over the $1 million to his personal IRA. However, there’s a strong likelihood that he could have rolled over the $1 million via a direct trustee to trustee transfer into an inherited IRA account.
– Usually, under the terms of an inherited IRA account, John would have been able to withdraw a minimum amount each year over his expected lifetime (as calculated by a specific formula). Or, if he preferred fewer distributions (for example, over 10 years), he could have requested that, receiving an annual payout of $100,000 for each of those years. In either case, that would have left money in the account to appreciate, income tax deferred, for an extended period of time.
– And, John’s yearly income taxes for the annual withdrawal from this IRA would have been significantly less burdensome than the income taxes on the $1 million he received in a lump sum!
The rules for inherited IRAs are very complicated. Depending on the circumstances, different rules may apply. If the rules are not properly followed, the IRA beneficiary may end up paying higher taxes or penalties along with forfeiting opportunities for future tax-advantaged growth. Given the potential pitfalls all along the way, it is best to contact an expert, such as an estate attorney or financial advisor, to help insure that you are managing your IRA inheritance in a way that meets your needs and minimizes annual income taxes while optimizing long-term financial growth.
Experienced Estate Planning Attorney, Elga A. Goodman, can help you successfully navigate through the maze of rules and regulations associated with inherited IRAs. Contact us today at 973-841-5111.
The information contained herein is for informational purposes only and should not be construed as legal or tax advice. The persons and situation discussed are fictional. Any resemblance to real persons or to real life examples is purely coincidental.
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