Mark's dad was a diligent, longtime investor, and when he passed away in late 2020, Mark inherited his dad's substantial IRA.
Mark enjoyed investing—he’d learned from his dad over the years—and he wanted to do the right thing with his dad’s money.
But he was used to making and investing contributions to his retirement account. Now, he had to think about the optimal way to withdraw from an account.
He wished he could talk about it with his dad, but instead, he called us because his dad had trusted FundX for years.
“Should I keep the IRA invested as long as possible to try to grow the account or would it be beneficial for me to withdraw some of the assets each year?” he asked.
New rules about inherited IRAs
Managing an inheritance can be challenging (get our tips here), and there are additional considerations to make if you inherit an IRA, like Mark.
The SECURE Act, which passed in December 2019, requires beneficiaries to liquidate inherited IRA assets within 10 years (assuming a beneficiary is not the spouse, disabled, chronically ill, or a minor child, and is more than 10 years younger than the account owner).
Previously, non-spouse beneficiaries could withdraw assets from an inherited IRA over their lifetime, which gave beneficiaries the ability to take money out of the IRA relatively slowly, stretching out the tax deferral for many years.
Since Mark inherited the IRA after 2020, he had 10 years to distribute the assets from his dad’s account, which is potentially less tax-efficient: because inherited IRA distributions are now condensed over a single decade, they are more likely taxed at higher rates. But beneficiaries do have some flexibility: they can take money out of an inherited IRA gradually over that 10-year period or all at once at the end of 10 years. Which is the best inherited IRA tax strategy for you?
Here are some of the pros and cons of two inherited IRA strategies:
Strategy #1: Delayed distribution
Delaying distributions allows the assets in the IRA more time to grow, so this is a good approach if you have meaningful, steady income, and you don’t expect to withdraw from the IRA to meet spending needs.
It’s also the ideal approach for inherited Roth IRAs since these assets can continue to grow tax free for 10 years.
Strategy #2: Gradual distributions
If taxes are a concern, then distributing the IRA over time could be beneficial because you’ll have smaller distributions each year, which could help you stay in your current tax bracket and avoid taking a distribution that pushes you into a higher tax bracket.
Additionally, if your income varies from year to year, you could choose to take more at the end of a leaner year and less after a banner year.
If you don’t need the money right away, you could reinvest the distributions in a separate, taxable account in an attempt to grow your inherited assets in a tax-efficient manner (based on your income tax sensitivity).
The gradual distribution approach is worth considering if you have generally modest income (facing lower tax rates) and you don’t necessarily need the distributions to fund current spending needs.
When to consider a blend of strategies
It helps to compare each of these scenarios—full distribution at the end of 10 years (if your income is stable) versus looking for opportunities year by year based on your tax bracket or needs—with your advisor or financial planner. This analysis can help you customize your distribution strategy to your needs or determine if a blend of these two approaches may be appropriate.
A blended approach could be advantageous if your income level is less predictable or if you expect to retire at some point within the 10-year period and want to delay a majority of distributions until you no longer have earned income.
Mark ultimately decided to work with an advisor who could help him come up manage his inheritance in a way that works for his goals and needs and also help him avoid taxes when possible. He still manages his own IRA, though, just like his dad.
Could an advisor help you strategically manage your inherited IRA? Set up a time to talk with a FundX advisor (it's free and there's no obligation).