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Why you need to carefully consider who inherits your IRAs

On Behalf of | May 18, 2024 | Estate Planning

For many Americans, particularly those who are middle age and older, a large percentage of their wealth is in individual retirement accounts (IRAs). They may be comprised of funds rolled over from employer-sponsored 401(k) plans as well as money they’ve contributed each year to help minimize their taxes. The idea behind IRAs is that people can deduct the amount they contribute on their income taxes each year, and the money isn’t taxed until they make withdrawals (known as distributions), which is typically in their retirement years when they’re in a lower tax bracket.

It’s only natural to want to leave any funds remaining in the accounts when you pass away to loved ones. However, it’s crucial to know (as with any inheritance) what kind of tax effect it could have on the beneficiary. IRA inheritances can leave some beneficiaries with an unexpected and unwanted tax burden. 

It used to be that if someone inherited funds from an IRA, they had the rest of their lives (or at least their estimated life expectancy) to take distributions on those funds. That means they could conceivably stretch out the tax burden on a large IRA inheritance over many years.

What are eligible designated beneficiaries?

That changed about five years ago with a new federal law called the SECURE Act. Among other things, it changed the way IRA inheritances are taxed for some beneficiaries. 

The law designated certain people as eligible designated beneficiaries (EDBs). These are family members presumed to have the greatest need for someone’s IRA assets after they pass away: 

  • Surviving spouses
  • Minor children (but only until they become legal adults)
  • Disabled or chronically ill beneficiaries (whether family members or not) and trusts set up for them
  • Any beneficiaries less than ten years younger than the deceased

These beneficiaries still have their estimated life expectancy to take distributions on their inherited IRAs. However, any IRA beneficiary who doesn’t qualify as an EDB must take full distribution of the inherited funds within ten years. 

If an IRA inheritance is a few thousand dollars, that won’t have any significant tax implications. If a non-EDB is left a $500,000 IRA, however, they could get thrown into a much higher tax bracket for the next decade.

Laws like this, which most people don’t even know about, are one reason why having experienced estate planning guidance is crucial to ensuring that your legacy to loved ones is a blessing rather than an unintended curse.