Quick question: Would you prefer to inherit—1. A $200,000 portfolio of stocks and bonds, or 2. A $200,000 IRA invested in the same stocks and bonds? All things being equal, the IRA should be your second choice since it comes with an income tax obligation. Most inherited assets are given a basis step-up at the death of the owner. That means if the beneficiary sells the asset soon after acquiring it, there will be little, if any, capital gain to be taxed.  This rule does not apply to inherited IRAs. Ordinary income tax will have to be paid on all distributions from an inherited traditional IRA (but not from an inherited Roth IRA, those distributions are tax free).

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What happens to IRA money that remains in the account after the owner passes away? Estate planning for qualified retirement plan benefits is an especially tricky area of tax practice. In general, remaining funds must be distributed to beneficiaries during the ten years following the owner’s death. (An exception applies when the beneficiary is a surviving spouse, and to certain other beneficiaries.). This “ten-year rule” was established with the passing of the SECURE Act in 2019.

In February 2022, the IRS proposed Regulations for implementing this law, a proposal that added a new wrinkle.

Traditional IRAs are subject to “Required Minimum Distributions” (“RMDs”) after the account owner reaches age 72. The amount of the distribution is a percentage linked to the account owner’s age, as provided for in IRS actuarial tables. The older one gets, the larger the percentage becomes. (Roth IRAs do not have RMDs)

For a traditional IRA, if the owner dies before age 72 the person inheriting the IRA has complete freedom on how they withdraw the money over the ten years. All withdrawals will be subject to income tax at ordinary tax rates, so taxation can be spread over ten years by withdrawing one tenth every year. Alternatively, the beneficiary can also choose to leave all the money in the inherited IRA until the tenth year, for maximum tax-deferred growth. (Again, different rules apply to surviving spouses.)

Under the proposed regulations, an additional rule applies if the owner dies after his “required beginning date,” which is generally April 1 of the year after the owner reaches age 72. In these cases the beneficiary must receive some money every year, based upon life expectancy, and leaving the account alone until the tenth year is not available.

What about the Roth IRA?  The minimum distribution rules do not apply to Roth IRAs so there is no requirement that the inherited Roth IRA make any distributions at all until the tenth year, allowing for maximum tax-free growth in the account. The beneficiary is free to withdraw earlier, if desired, and all such withdrawals will be tax free.

Retirement income management can be almost as complicated as accumulating retirement capital during the working years. The many tax rules can be unfamiliar and, frankly, baffling. This is especially true when retirement plan assets, such as IRAs, are a substantial portion of the bequests to heirs. These complications should be taken into account during estate planning and an Arvest Wealth Management Trust Officer will be pleased to work with you and your tax and legal advisors to help you create a plan for your legacy.

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This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.

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Arvest Wealth Management does not offer tax or legal advice – consult a professional.