We have written several aspects about the role IRAs can play in your comprehensive estate planning strategy, as well as several concerns that accompany them. Here, we will address the two common choices facing non-spousal individuals listed as heirs for an IRA account that is not slated to go to a trust for that individual heir. These two choices are to take a lump sum withdrawal or to keep the account invested. Each of these may have different consequences for an individual heir that are important for everyone to keep in mind.
Lump Sum Withdrawal
Non-spousal IRA heirs have the option to elect to make a lump sum withdrawal of the assets within the IRA. Choosing this option could be beneficial on several levels, such as enabling the heir to make use of a large sum of money for important large purchases like a house or renovations. It could also enable them to pay off otherwise crippling debts. However, inheriting a large sum of money all at once can carry complications, some of which are determined by the amount within the IRA as well as the type of IRA.
For a traditional IRA, contributions to the account are tax deductible. As a result, withdrawals or inheritances of assets within the IRA are taxed like ordinary income. That means the heir needs to be prepared to potentially pay a great deal more in taxes in the year that an IRA inheritance is received. Roth IRAs do not provide a tax break for contributions, but may allow a recipient to make withdrawals without hefty tax consequences. An heir can also consider dividing withdrawals among multiple tax years to help lower the cost of the inheritance.
Keep in mind that if the heir is married, it may be a good idea for them to deposit proceeds from an IRA inheritance into an account held solely in their name. While not a complete protection against access, it could help keep the inheritance out of the reach of a spouse in case of divorce. Likewise, individuals inheriting an IRA prior to marriage should take steps to specifically identify those assets as their own in a prenuptial agreement in order to help preserve and protect them.
Keeping the Account Invested
For heirs that do not immediately depend on an IRA inheritance, keeping the account invested could be a good idea. By electing to keep the account invested, it will continue to grow in value over time. This option may trigger the need to make mandatory minimum withdrawals from the account. Failing to do so could result in penalties from the IRS.
If an heir chooses this option, they will need to take the same steps to protect this investment as the original owner of the account. In other words, they will need to properly title the IRA and make sure that they update beneficiary designations for the account. The IRS also has strict rules for this process, rules that an experienced estate planning attorney can help you and your heirs understand. It is extremely important to make sure that your heirs are aware of these types of requirements, so discussing your plans for these types of assets with the heir of your choice is a crucial part of this process.