Ep #119: Demystifying the Inherited IRA RMD Rules

Benjamin Haas | Jun 4, 2024

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00:00:04 Benjamin Haas:

Hi everyone and welcome to A/B Conversations where we will help you CFP your way out of it. A podcast where you get into the minds of a couple of Certified Financial Planners on how we think and feel about everyday financial planning questions and what should really matter most to you. A healthier financial life starts...now! Hey Adam. How are you today my friend?

00:00:31 Adam Werner:

Oh, doing great. I was going to say just peachy, but I'm pretty sure I said that on a recent podcast and you made fun of me. So doing great. Thank you.

00:00:39 Benjamin Haas:

Wonderful. I'm very happy to hear it.

00:00:42 Adam Werner:

How are you?

00:00:43 Benjamin Haas:

I'm peachy, thanks! So, topic for today and I think I'd like to introduce this and speaking to an audience that I would say we often speak to like our clientele, who are in that phase of life where they're having new big things happen with them in their life. Maybe they're getting close to retirement, but I want to think about the situation where maybe they've inherited money, right? They're at that age where hopefully their parents lived a long and healthy life, or maybe it's an aunt, maybe it's an uncle. Whoever you inherited money from, you're now in this spot where you have to take on something that you may not have been planning for and don't know all the rules around, or we recently did a podcast on caring for aging parents. If you're in that spot where you are having to care for them physically or starting to get a grasp on what their finances are, if you're financial power of attorney, something like that, this concept of inheritance specifically around these retirement accounts, inherited IRAs, it is a really confusing thing for people so we should really talk about it.

00:01:54 Adam Werner:

Yeah. I think not only can it be easily confusing. I think just the something as simple as just the way that different generations approach their finances or how open they are with their finances, you know, to your point.

00:02:11 Benjamin Haas:

Not open about their clients.

00:02:12 Adam Werner:

Right, right. More specifically. I think that is the case that we're certainly feeling for our pre-retired and retired clients that it's often, well, I feel like we did talk about this in a long-term care kind of focused podcast or caring for aging parents, the financial aspect of, later in life, if it is financial power, attorney, whatever that looks like now they get to see how things are structured and it often does not mirror how the baby boomer generation has been structured. Some of that's just not phase of life, but the time and period in which they grew up, the instruments that are available for a retirement perspective are just vastly, vastly different.

00:02:59 Benjamin Haas:

Be specific. I mean, that generation, your retirement was a pension and social security. That doesn't really include the next generation, your heirs. Now we're in this defined contribution plan, right? These 401ks, 403bs. What may eventually be an IRA or it started as an IRA contributory IRA. These are the vehicles that do have beneficiary designations and can go to the next generation. So this is, I think a great topic. We are like 120 podcasts in and haven't dived too deep into this one yet. We want to do it from the viewpoint again of a client here who has been asking us questions and I'd say let's just start at the top. There's been a lot of rule changes around RMDs, required minimum distributions. Let's maybe just start there. What are RMDs? What are the rules? And then I'll say, let's shift our focus to, okay, now that we have that baseline knowledge together, when we're having these conversations with clients, what could we proactively do? You know, to maybe manage the situation or if you have inherited something, what do we, from a reactive standpoint now, how do we manage that once money is in your name?

00:04:09 Adam Werner:

Yeah.

00:04:09 Benjamin Haas:

So take it away, Adam.

00:04:11 Adam Werner:

So just to clarify, when we talk of RMDs, required minimum distributions, this is all going to pertain to retirement accounts. So, what is an RMD? It is essentially a forced distribution or a forced withdrawal on certain retirement accounts that have been tax deferred up until a certain point. For normal retirees right now, that RMD age is age 73. Once you hit age 73, the IRS says, you haven't paid taxes on these dollars yet, now's the time.

00:04:44 Benjamin Haas:

Yeah. Uncle Sam knocking on the door.

00:04:46 Adam Werner:

Yep. Now's the time to pay a little bit to the Piper, to Uncle Sam so they can get their cut of that tax revenue.

00:04:53 Benjamin Haas:

So how was that determined?

00:04:56 Adam Werner:

There's a calculation, believe it or not, there's a formula. There are tables on the IRS website. There are many financial calculators out there, but essentially it just goes off of your prior year end balance or your January 1st of that year balance and then there's this grid formula, it ends up being a percentage but that's how it's calculated. It's based on your age, the older you are, the higher that percentage of the account is forced to come out and pay taxes on and it does depend on your account balance from the end of the prior year.

00:05:32 Benjamin Haas:

So then thinking how we put this into practice, it would be fair to say many people who retire before age 73, and may be taking withdrawals from their retirement accounts to support their lifestyle, right? They have to replace their paychecks. So that minimum amount is just to make sure that you are taking something out so that Uncle Sam gets paid. If you, I'll say if you are fortunate enough to maybe not need a lot of that, those retirement dollars, you have income coming from a different source, whatever that situation may be, it is to make sure that the IRS is getting something by that age because you have deferred. So, I guess where it gets tricky and I'll toss this back to you. There's been some rule changes, including when these things even had to start, you said 73. For those that maybe were in the know on certain things, it used to be 70 and a half and 72. Now it's 73.

00:06:29 Adam Werner:

Right, and at some point in 2033, I think it'll then flip to age 75 and that's more straightforward. That once you hit that certain age, you're going to be forced to take out some minimum amount from your retirement account, that's all fairly straightforward, where it does get really tricky is when you inherit a retirement account.

00:06:53 Benjamin Haas:

This is like the meat of it. So let's go through these deep. Well, get as detailed as you want, but this is where it does get confusing and I'll admit again, we had a client situation not that long ago where I sat there and froze. I'm like, oh man, I hope I have this right. Like it is tricky. So, do your best.

00:07:13 Adam Werner:

Well, part of the issue is these rules have been changed over the last few years. So, I won't necessarily get into what they were like before. But even as we're seeing this year, I think the IRS put out more clarifications on their interpretation of their own rule to clarify not only for advisors, but for everybody in this camp of inheriting a retirement account. So, the key point when you inherit a retirement account now is there is a 10-year window in which you are going to be forced to exhaust that account. Well, now I'm going to go against my word. Previously, you could, again, I should say it depends on your status as the beneficiary, your relationship to the person who has passed does dictate some of these rules. If you are a spouse, you can essentially just roll it into your own retirement account and avoid some of these rules. But for the focus of this conversation, we're thinking like next generation, or to your point, aunt, uncles, whatever that case may be. You have a 10-year window and you now have to take this account down to zero. Again required distributions because the IRS wants some tax revenue back that they haven't yet accumulated but where it gets really confusing is depending how old the person was who passed, if they were already of RMD age, whether that was 70 and a half, 72, 73, you not only have to exhaust that account in a 10 year window, but you also need to at least take a little bit, you have to take your own amount of an RMD in each of those given years until the account is exhausted. That's where it can get a little bit tricky and understanding, you know, if this, then that in terms of like this flow chart of when RMDs are needed on inherited accounts. Roth IRAs, if you inherit a Roth IRA, even though those distributions will not be taxable, you still need to exhaust those within a 10-year period. So that's where there are potential strategies there to maybe you let that ride if you don't need it, because it's all going to be tax free growth until you need to take it out. But an important clarification while you're living and you have your own Roth IRA, no RMDs are needed, but if you inherited a Roth IRA, you do need to exhaust that within a 10-year period regardless of the tax impacts.

00:09:35 Benjamin Haas:

Yeah. Oof. Take a deep breath.

00:09:38 Adam Werner:

Yeah. It's a lot.

00:09:39 Benjamin Haas:

So now I'm trying to be client here. Not that we're going to get into role play on our own podcast here, but now I'll be client and I say, Adam, how does this even get tracked? Like I've got 10 years to do this. How do I know when that clock starts? What I have to do? Who's going to notify me?

00:09:57 Adam Werner:

Yeah, and I guess this is a really crappy part, like a lot of things with the IRS. It's on the taxpayer. It's on you really. It's on us, on you to really track that and make sure you are meeting those required minimums.

00:10:14 Benjamin Haas:

So, then the follow-up question has to be, for anybody that's in this situation and again, speaking to, if you're listening to this podcast, it's because you kind of care about financial planning and like learning things. You probably either have been in this situation or will be in this situation. Well, you're inheriting something. If you fail to meet your obligation according to the IRS, then what?

00:10:37 Adam Werner:

Yeah, so again, these rules have changed. It used to be a 50 percent penalty. Essentially a 50 percent excess tax. So, if you needed to take out $2,000 from your retirement account, and you didn't do that by December 31st of that given year, in theory, your penalty was half of your RMD. Now it's 25%, is the penalty. There is a way to essentially ask for forgiveness. There is a process to go through. There's a form that you need to file with the IRS, along with an explanation of what happened. Why did you miss it? And you're basically asking for forgiveness and saying, I won't let this happen again and we've had clients in this situation. Does not happen frequently to actually have to go through that, ask for forgiveness and please waive this excess tax and we've never had somebody not get that waiver of the tax. But that is a rule and it does happen.

00:11:35 Benjamin Haas:

Okay. So, with that as the foundation, let's move into strategy time. You know, people ask these questions because ultimately, I think they're coming from a place of I want to do the right thing. Some of this is confusing. It would be our job to kind of understand their situation, to be able to talk through maybe the best way to handle it, but let's maybe start with. If you have now inherited something and let's live in the world that this is taxable. Where would we start that conversation knowing that there is essentially a 10-year window where they have to take this money out?

00:12:12 Adam Werner:

Yeah, I think the first variable is really just the taxes. So sometimes it may just depend on where that person is at on their income earning, you know, career path. It may make sense to spread out withdrawals over that 10-year period, just to also then spread out the taxes. It may be something as simple as if, you have an idea or you know that you're going to have lower income earning years, and maybe some years where you're going to earn more, it may make sense to accelerate those withdrawals in years where your income is going to be lower, or maybe more specifically to our clientele. If you inherit an account like this, but you know, you're going to retire in a couple of years and your income is going to drastically drop, it may make sense to only take the minimum until you are retired to then take advantage from a tax standpoint just to shift income as much as you can in years where it's just more advantageous to you from a tax standpoint.

00:13:15 Benjamin Haas:

Yeah, this is where I feel like we've been in situations where we've given the advice, maybe it doesn't make sense to rip the band aid, you know, there is certainly a psychological component to this. You know, if you are inheriting something, you may also be in the spot where you're the executor or the executrix of that estate and you start to think about, all right, I just want to consolidate things. I want it to be simple. I don't want this to feel complicated. You know, then there is the timing of things where if it's maybe not a big balance, you still look to spread it out over two years or three years. So, I think starting with the tax conversation is probably the most important spot because that's really what the boils down to. You're required to take money because the IRS wants their taxes and more often than not, unless this is maybe coming from a grandparent, more often than not, we're looking at clients getting this within a window that is usually their highest earning years. Close to, you know, so I don't want to jump to maybe how we can be proactive with this, but it is important to recognize that you were going to pay income taxes at your tax bracket. Anything that's coming out is going on top of everything else that you have going on from a tax standpoint.

00:14:30 Adam Werner:

Yeah. So maybe I'll throw the softball back to you. If we're building that scenario where maybe you're in your prime earning years. You may not necessarily need these funds from the inherited retirement account. What are some other alternatives so you're not going to be forced to take this money out. What do we say? Or what are some options on, I may not need this. What should I do with this excess cash?

00:14:58 Benjamin Haas:

Yeah. I appreciate the softball because you just said this like very recently. You can kind of take from Peter to pay Paul, right? If you are earning and maybe you haven't maxed contributed to your own retirement plan and you're forced to take this money out. You could take that out right now that's taxable, but then match that by deferring it into your own plan, which you're going to be able to control when you want to take withdrawals later in your life. So that would be one, I would call it relatively simple way to kind of just kick the can down the road and meet that obligation.

00:15:34 Adam Werner:

Yeah.

00:15:34 Benjamin Haas:

What are your thoughts?

00:15:36 Adam Werner:

Yeah. The other side of that is if what's in that scenario where, well, what if I'm already maxing out my 401k at work and I don't have the ability to continue to save in a retirement account, what else should I do with it? Well, that's where a non, very scientifically named, non-retirement, right? A taxable investment account. If the idea is, hey, I don't need this, but I don't want to just stick it in the bank. Although, you know, interest rates are at least earning something. You could invest it, reinvest it, right? If it's already invested in a retirement account, take it out, pay the taxes, reinvest it in a non-retirement account. It's going to be a little bit more favorable from a tax standpoint moving forward, but that way it can at least be reinvested to continue to grow and continue to compound until you do need it. Or again, that could just be kicking that can down the road. If you don't need it, then that's for the next generation as well, which again, we're focused on the retirement account side of things, non-retirement accounts do pass to the next generation more efficiently from a tax standpoint.

00:16:36 Benjamin Haas:

Yeah, and I'd also say on that thought of like kind of reinvesting, I think the timing of where the market is not that we are market timers, right. But I think psychologically we know when we try to coach our clients through the process of trying to think opportunistically and we know down markets are going to happen. So, what are maybe some of the things to do when down markets are happening? If you have these RMDs, why not take it at a more depressed rate of return, now reinvested over into a place where we know that the market's going to come back up, right? Historically, it always has reached new highs. Why not have that recovery occur in a more tax advantaged spot? So, if we're keeping lists on like, who has to take what and what's the 10-year period that they have to do it. If 2024 or 2025 is the next down year we would bring that up. That seems like theoretically a good time to be doing something like that accelerating your withdrawals.

00:17:34 Adam Werner:

Yep. Which is a perfect segue into the, okay, so now if we're creating this scenario where that older individual is still living, right. But wants to be more proactive while they're living to try to limit some of those tax impacts, maybe not necessarily so much for themselves, but over multiple generations, that idea of using a market downturn to your advantage is a perfect opportunity to do a Roth conversion.

00:18:02 Benjamin Haas:

Sure.

00:18:03 Adam Werner:

So, it's not only for once you've inherited it. Great. Take the money out, pay the taxes, and now have your growth in a different spot. That's maybe more tax advantage. It's a great opportunity to do a Roth conversion while you're living as well. Again, pay taxes potentially on a lower balance. Now, all of that growth, hopefully moving forward is going to be in a Roth IRA account. And also, as we said earlier, even when a Roth IRA is inherited, they do have to exhaust it, but they're still not taxes owed by the beneficiary who is inheriting that. So that could be a win situation and using the markets downturn to your advantage.

00:18:40 Benjamin Haas:

You mentioned it earlier. We don't want to put ourselves in the spot where we're making anyone uncomfortable by suggesting that you have to openly talk about your finances with either your parents or your children, but we certainly have been in those situations where when we ask the priorities of retired individual that may be getting up there in age, how do you want things to go? How do you want the structure? If we ask them, who do you want to inherit this? The IRS is not on the top of that list, right? You don't want that to be your third child. You know, there is some proactive planning that could be done then and if you are certainly at a lower tax bracket than your heirs would be, then starting to manage more aggressively, some of those withdrawals, I get it. We have to prioritize things and there are plenty of people who go, look, that's their problem, not mine. But when you certainly outline some of the benefits of taking higher withdrawals to reinvest it in a different spot. This could be a win for both you and your heirs by reducing this problem that we're calling it of inheriting taxable dollars. Yeah, that's income taxable dollars.

00:19:55 Adam Werner:

Yeah, that approach takes, I mean, it certainly takes the right individual that to take that very long-term approach, right? You're playing the long game from a tax perspective where I'm not just worried about the taxes that are going to be paid on these dollars while I'm living. It's how can we just limit the amount of taxes over my generation, the next generation and not everybody thinks that way to your point. But with people who do think that way, this wealth isn't just for me, it's for multiple generations. There are a lot of things that can be tweaked or can be adjusted to just limit as much as you can over time, those tax bites.

00:20:36 Benjamin Haas:

We should have started here, Adam. Like, let's take a poll of two here. You and me, and I'm sure everybody listening. Do you believe tax rates are going up or down? I think they're probably going to go up over time and I think we hear that a lot. So, if that is the assumption, then what can we do? This is not to pass judgment. I think you said it a little bit earlier. You used to work for a company. You worked for that company for a very long time. They gave you a pension. That was your retirement. This is not to say that anyone's done the wrong thing by building wealth in a retirement account. It's a wonderful thing. You did the right thing. You saved, you put yourself in a good spot. If there's something going to be left over, then there is absolutely proactive conversations to be had. And if you were the child that's now trying to help mom, dad, aunt, uncle, whomever manage some of these decisions, we can help you have those conversations that kind of illustrate to a degree what those options are. I mean, we didn't mention the throw it back to you, especially if they're in a spot where they do need care.

00:21:39 Adam Werner:

Yeah, and I think we did talk about that recently on different podcasts. The idea of proactively taking more than your minimum withdrawal to help spread out some of those taxes, right?

00:21:50 Benjamin Haas:

The idea is if it is a minimum.

00:21:53 Adam Werner:

Right. If you're assuming that people who are going to inherit these funds are going to be paying more in taxes than you are may make sense to take more, but to your point, if there are long term care expenses being paid, you're going to be able to deduct a good amount, assuming the situation, but you're going to be able to deduct some of those medical expenses. The perfect opportunity to take withdrawals from a retirement account and offset some of those taxes that may do may be due with the deduction on those medical expenses in a given year. So, there are ways to essentially take withdrawals, not pay a whole lot of taxes because of specific expenses that are deductible.

00:22:33 Benjamin Haas:

It is a lot.

00:22:33 Adam Werner:

It is a lot. That's why we're here.

00:22:37 Benjamin Haas:

So, maybe I'll try to put a button on it and you can add your two cents at the end. A lot of what we have talked about on this podcast for, I don't know how long we've been doing this now, four years. It has been centered through some of the behavioral finance things that we're learning or just our understanding of emotions and the values that people bring to these conversations. A lot of these questions that we get in a lot of the situations that we just illustrated clients having to take care of parents. It is an emotional time and that weighs into frustrations that come when things feel really complicated. So again, it's not easy to talk about money sometimes. We know it's an emotional topic. It's important to just have the discussions and if we are invited into those discussions with you, it really helps us take all of these complications and funnel it down to, well, look, if this is really what matters most to you, here are the next steps that we can take and just try to simplify it as best we can for somebody.

00:23:42 Adam Werner:

Yeah, and the only other thing I'll add is that I think what ends up being difficult for a lot of people is, we live and breathe this stuff, but until someone experiences either a parent passing and having to deal with that inheritance themselves. That's when they really learn these rules and at that point it's often too late to do anything. Even if there's not any proactive, you know, adjustments that could be or should be made. Just understanding the rules in this realm can be a difficult thing to go through and kind of learn on the fly when it's just not something that you're aware of, or not something you're interested in, right? The nitty gritty details of taking withdrawals from a retirement account. That is not in everybody's wheelhouse. We don't take that for granted so it can be difficult.

00:24:29 Benjamin Haas:

And I'm looking at it. It's sitting on my desk, individual beneficiary form. Number one payment option on here for the beneficiary of a retirement account: lump sum payment. It sounds like something I would want to do, right? I want to, I'll take it as a lump sum and now that person would pay income taxes on, in this case, $200,000.

00:24:51 Adam Werner:

Yeah. I would love for you to do that.

00:24:53 Benjamin Haas:

But it's hard. I don't, nobody who really knows what a trustee-to-trustee transfer is? Spousal continuation. What do these things mean? It's unnecessarily complicated, but that's why we're here.

00:25:07 Adam Werner:

We're here to be a resource as best we can.

00:25:11 Benjamin Haas:

Thank you, sir and you're a good one at that. Have a great rest of your day. Till next time.

00:25:16 Adam Werner:

Likewise. Thank you.

00:25:18 Benjamin Haas:

See ya.

00:25:19 Adam Werner:

Bye!

00:25:26 Benjamin Haas:

Hey, Adam and I really appreciate you tuning in. Please note that the opinions we voiced in the show are for general information only, and are not intended to provide specific recommendations for any individual to determine which strategies or investments may be most appropriate for you. Consult with your attorney, your accountant and financial advisor or tax advisor prior to making any decisions or investing. Thanks for listening!

Investment Advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Haas Financial Group are separate entities. This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice.

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Ep #119: Demystifying the Inherited IRA RMD Rules