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The potential tax burden of an IRA inheritance on your loved ones

On Behalf of | Dec 17, 2021 | Estate Planning |

Your individual retirement account (IRA) is primarily intended to provide you with a regular source of income in addition to Social Security. To designate whom you want to receive whatever is left when you pass away, you need to list them as beneficiaries on your IRA with the financial institution or whoever holds it. 

Since IRAs have very specific distribution and tax requirements for those who inherit them, it’s crucial that your beneficiaries know about them and that abiding by them won’t cause them serious tax consequences. A bill that was signed into law nearly two years ago makes things even more complicated.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act did away with the ability for many traditional IRA beneficiaries to space out their distributions from the account over however many years their projected life expectancy gave them. Under the new law, any beneficiary who is not considered an “eligible designated beneficiary” must take full distribution of the amount they inherited within 10 years.

Who qualifies as an eligible designated beneficiary?

Fortunately, there are exceptions for those defined under the law as eligible designated beneficiaries. These are people who are most likely to need their IRA inheritance over a long period or the remainder of their lives. They aren’t held to the 10-year rule. They can use the previous life expectancy distribution plan to take their distributions.

Here are the categories of eligible designated beneficiaries:

  • Surviving spouses
  • Disabled and chronically ill beneficiaries (if they qualify) or trusts set up in their behalf
  • Minor children (but only until they turn 18 or their state’s age of majority)
  • Any beneficiary who is less than 10 years younger than the decedent.

Since income taxes are paid on IRAs only when they’re distributed (to the account holder or their beneficiary), the tax burden a beneficiary can face on a large inherited IRA if they have to take a full distribution within a decade can be significant. As you’re developing your estate plan, it’s wise to consider the potential tax consequences of your generosity (if you can’t avoid or at least minimize them) and make sure that those who will face the tax consequences are fully aware of them.

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