If your clients are like many people, a good portion of their retirement savings is tucked away in an IRA, and the odds are they will need every penny once they put their working years behind them.
But what if it turns out the client doesn’t need that money? What if they’re one of those fortunate people who has other assets that can be used to pay the bills and fund their retirement lifestyle? Instead of spending the money accumulating in their IRA, they can decide to include it as part of the legacy they plan to leave to their beneficiaries.
If clients take that route, there are a few things worth knowing to make sure they limit how much their heirs owe in taxes when the IRA comes into their possession, allowing the heir tomaximize the amount of inheritance they can call their own.
Their heirs may face a deadline. Adult children and many other people who inherit an IRA must empty the account within 10 years. Of course, with each withdrawal they make, taxes come due. This 10-year-empty-out-the-account requirement doesn’t apply to everyone, though. Spouses, minor children, and disabled or chronically ill heirs can extend their IRA disbursements for the rest of their lives, if they so choose.
The timing of a client's last required minimum distribution makes a difference. If their retirement savings is in a traditional IRA (or any tax-deferred account), they are subject to required minimum distributions (RMDs) when they reach age 72. In essence, that means they have to withdraw a certain amount of money each year whether they want to or not so the IRS can collect the taxes from them.
What does this have to do with their beneficiaries and an IRA they leave behind? If they die early in the year, before they pay that year’s RMD, the IRS still wants its money. It will fall to their beneficiaries to make sure the taxes are paid.
A Roth conversion can help eliminate their heirs’ tax burden. If they don’t want their beneficiaries to be saddled by the tax bill they have left behind, one good option is to begin converting a traditional IRA to a Roth IRA. If the Roth account was opened at least five years before you die, then heirs don’t pay taxes when they withdraw money from the account. The client, however, must pay taxes when they make the conversion, so it’s best to spread the conversion out over several years to avoid a big tax hit all at once.
Finally, let’s say that instead of bequeathing an IRA to someone, they are the one on the receiving end of an inherited IRA. What should they do with this sudden, possibly large chunk of money that’s now in their possession?
Although they might be tempted to withdraw all that money at once, pay the taxes, and splurge on some luxury item for themselves, that’s not the most prudent approach. They would be better off just stretching those withdrawals out over the 10 years because at least the money’s there for a decade.
But they do have other options and, with the right planning, can make those withdrawals in a thoughtful manner that will benefit them the most. For example, they might time withdrawals with their overall tax situation, drawing out more money during a low-income year and less during a high-income year when the withdrawal could bump them into a higher tax bracket.