If you've inherited 1 million dollars it's exciting – really exciting. But if you've inherited 1 million dollars in an IRA it's exciting too – but also complicated. I received an Ask GFC question on exactly that topic recently:
Hi Jeff, thanks for all you do and keep up the great work!! QUESTION: if a 30 year old inherits a $1 million IRA from Grandpa and that 30 year old converts it to an IRA in his name he will pay 50% in taxes thus reducing the $1 million to $500k (correct?) What are his alternatives? if he keeps grandpas IRA titled in grandpa's name FBO himself then he must start taking RMDs the year he inherits the money regardless of either grandpa's age or his own age (is this correct?) What would be your recommendation for a 30 year old with no extraordinary wealth that inherits a large sum of money? Thank you!!!
If you've inherited 1 million dollars in the form of an IRA, it's real wealth, but wealth with some major strings attached to it. The money is yours for sure, but there are a lot of limitations as to what you can do with it, it even how much access you will have to it.
With that in mind, let's set out to try and help this reader sort out his or her options.
The General Rules on Inherited IRAs
We have to start the discussion with an important distinction. There are two types of beneficiaries who can't inherit an IRA, spouse and non-spouse. The situation with spouses is pretty simple. You can roll the inherited IRA into an IRA under your own name (where you can even convert it to a Roth IRA), or you can roll it over into an inherited IRA account, where you can take withdrawals before turning age 59 1/2 without having to pay the 10% early withdrawal penalty.
But since the reader is indicating that this IRA is being inherited from his grandfather, we're going to focus on inherited non-spouse IRAs.
With an inherited non-spouse IRA the beneficiary could be just about anyone – a child, a grandchild, a sibling, or even a close friend. The naming of a person as a beneficiary has important legal consequences. That's because an IRA beneficiary designation outweighs a will. That means that even if the beneficiary is not listed in the decedent's will, he or she will still inherit all rights to an IRA as a specific beneficiary of that account.
The IRA must be moved into a specific inherited IRA account. The custodian must register the account in your name, but also include the name of the person that the IRA was inherited from. This designation will establish the fact that the account is an IRA beneficiary distribution account.
“Distribution” is the operative word here! According to IRS rules, as the owner of a non-spouse inherited IRA you must begin taking minimum required distributions – commonly known as MRDs. Those distributions must begin no later than December 31, after the year of the death of the original owner of the IRA.
The MRD's are determined by the age of the original account owner at the time of death. There are two options:
The original IRA owner died after reaching age 70½.
You will have the option to elect to calculate MRDs either by using your own age, or by using the age of the original IRA owner at the age of his or her death. Using the original owner’s age will likely work out better if that person was younger than you at the time of death, because it will spread the payments out over more years, and therefore keep the tax liability lower.
The distributions must be taken based on the life expectancy of either you or of the original IRA owner. They are calculated based on the IRS Life Expectancy Tables.
The original IRA owner died before reaching age 70½.
In this situation, the original owner would not have been required to take required minimum distributions from the IRA during his or her lifetime. If this is the case, then you will have the option to withdraw the funds over a period of five years. That will enable you to completely distribute the IRA by December 31 of the fifth year after the original IRA owner's death.
Another important point: Distributions taken from an inherited IRA are subject to ordinary income tax. However, they are not generally subject to the IRS 10% early withdrawal penalty. That exemption is true even if the distributions are taken before you or the original IRA owner reaches age 59 1/2.
Still another really important point: When you roll funds from the original IRA over into an inherited IRA, you must be certain that it is completed as a trustee-to-trustee transfer.
There is no 60 day rollover provision in regard to a non-spouse inherited IRA. Once money is distributed from the original IRA, it is no longer eligible to be rolled over into an inherited IRA, or any other IRA account.
OK, are you still awake? Let's move on.
Taking a Lump Sum Distribution from an Inherited IRA
The reader's question references converting the entire balance of the inherited IRA account and paying something like 50% of the balance in taxes. I suspect – but I'm not sure – that what he or she is referring to is having to pay income tax on the entire inherited 1 million dollars that is sitting in the IRA account.
While that might be possible, it's neither necessary nor desirable. If you're going to transfer the money from the inherited IRA over into your own personal IRA, you will basically be moving money from one IRA to another. But that's basically what you're doing when you roll the money over from the original owner's IRA into an inherited IRA account.
The inherited IRA account is in your name, but includes the name of the original owner.
This will actually be to your advantage. That's because the bulk of the money from the original IRA will remain in the inherited IRA account, where it will continue to grow on a tax-deferred basis. But the advantage is that you can begin taking distributions from the account at virtually any age. You won't need to wait until you’re age 59 1/2, 65, or even 70 1/2. That's an excellent benefit, since it can provide you with an immediate additional income, as well as a retirement account that can last for the rest of your life.
Now there is always the option to use the accelerated distribution method, and withdrawing all of the money from the inherited IRA within five years. That will certainly give you access to the money much more quickly than if it’s distributed over either your life expectancy, or that of the original owner at the time of death. But it's probably not the best strategy.
With the accelerated distribution, yes you will get access to the money quicker, but you will also completely deplete the account, well before your own retirement, as this reader is just 30 years old.
The taxes are an even bigger consideration.
Paying the Taxes on the Inherited 1 Million Dollars From the IRA is an Issue All by Itself
By using the accelerated distribution method, you will also be increasing the amount of income tax that you will need to pay on those distributions. If you've inherited 1 million dollars, you will have to add $200,000 to your income each and every year for five years.
That can push you into the 33% tax bracket – or higher – causing you to lose at least one third of the distributions to taxes, and that doesn't include state income taxes.
However, if the distribution is done over the reader’s lifetime, which means that it may be spread out over 50 years or more, you're looking at an annual distribution of about $20,000. If you're in a 15% tax bracket, you will pay only $3,000 per year in tax on that distribution. In addition, it's unlikely that a distribution that small will push you into a higher tax bracket.
I would say that if you don't have an immediate and pressing need for the money, you should go with MRD's based on life expectancy. That will not only result in a much lower tax liability, but it will also preserve the IRA for many, many years to come. Think of all the tax-deferred investment income you can earn on a $1 million IRA from age 30! That alone should remove all doubt.
In closing, I'd like to acknowledge that inherited IRAs are pretty complicated beasts, especially one that's worth something like $1 million. For that reason, I strongly recommend that you consult with a CPA or tax attorney. Not only can they provide more specific advice, but they may be able to run some calculations that will clearly show the tax implications of the two different distribution methods.