Required Minimum Distributions on an Inheritance

One of the vagaries of the US tax code is dealing with retirement income from a 401k or an IRA. Both are similar investing vehicles, a 401K is usually offered by a workplace and people invest up to $18,000 a year of post tax income. IRA contribution limits are smaller (up to $5500 per year) and are used by self employed people or after leaving the workplace. It is normal once you leave a job to convert your 401K to an IRA under your control for example.

To avoid severe tax penalties you cant touch this money until you are 59 and are required to withdraw once you hit 70.5 years of age. The amount you have to withdraw at that age is called the Required Minimum Distribution or RMD. This is an actuarial calculated percentage of the amount, so the older you are the more you have to take out.

There is however one circumstance where you are required to take a minimum distribution prior to 70.5, that is when you inherit an IRA. This happens typically when a parent dies and the IRA or 401K is passed on to another family member through a will or beneficiary statement.

Usually if it’s a spouse’s IRA you can simply roll it up into your own IRA which is clearly the simplest option (Of course if you are over 70.5, then you are still liable to take RMDs).

The complication occurs when you inherit an IRA from a parent or similar. In this case you have several options. The first is that the IRS allows you to cash this out over the course of 5 years. As the IRA is considered taxable income then you will be subject to a tax penalty on this, but at least being over 5 years you are not likely to suddenly jump several tax brackets! The second option is you can cash out immediately, this enables you instant access to the money. However this is by far the least tax efficient way to do this as you will have a huge increase in your yearly taxable income and thus likely bump up several tax brackets. The potential for sticker shock here is huge. This should be avoided at all costs unless you have a compelling reason for needing the cash immediately to pay off very large interest loans such as credit cards.

The third option is in my opinion by far the best. This allows you to keep the IRA (you can’t combine it with others you may own) but does require you to take RMDs for the rest of your life. Again these values are based on actuary tables so if you have inherited an IRA in your 30’s or 40’s the actual amount you have to withdraw is only around 1-2% per year.

The great thing about this is assuming your IRA continues to grow each year in line with the market (say on average 6-8%) and you are taking out 2% each year in your 40s then you are generating effectively an immediate passive income revenue stream that will continue to grow.

Obviously none of this offsets the loss of a loved one, but this is in many ways the perfect inheritance. If treated properly this will fuel your own retirement and is ring fenced to allow proper spending and withdrawal habits.

This was a subject we needed to do a lot of research on last year as Tuffy inherited an IRA and we had absolutely no knowledge at the time about RMDs and the tax status of these bequests.

As 401Ks and IRAs are the biggest retirement vehicle these days it is increasingly likely that that this will be a major part of many inheritances we receive from our parents as well as a large part of any inheritance we might pass to our children.

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Roth IRA best kind of IRA to use to pass along to heirs. No RMD.