As investors working for companies, one may be entitled to invest into a 401k or 403b plan. Welcome to the club. You are part of about $5.3 trillion in assets with others out there who also hold a retirement plan at work. This represents about 20% of the $27.9 trillion in US retirement assets. In line with is something called an Inherited IRA. As the first generation of employees who started socking money away into IRAs and 401ks start to enter their elder years, the next generation of baby boomers are starting to inherit funds. What they are doing with these funds is rather unique.
An inherited IRA is exactly as it sounds. Monies are inherited but instead of taking a lump sum that is taxable, there is an option to transfer the retirement plan into an Inherited IRA. As a beneficiary, you can’t make additional contributions, but with an Inherited IRA the funds can remain tax-deferred, and you can generally withdraw money right away without a penalty. Inherited IRAs are typically opened for non-spouse beneficiaries, as spouses can transfer inherited assets directly into their own personal retirement accounts.
Inheriting a Traditional IRA from a Parent
Be careful. You can’t roll the inherited IRA into an existing IRA. The option you have is to open an Inherited IRA and you must begin withdrawing small chunks called Required Minimum Distributions (RMDs) no later than December 31 of the year after the account holder passed away. Here you’ll pay income taxes on distributions from the inherited traditional IRA. These distributions will be considered part of your annual income, and could bump you into a higher tax bracket. Conversely, if you don’t take the necessary distributions, you will incur a 50% tax penalty on the amount taken out below the RMD. But, most importantly, the funds continue to grow tax-deferred in this IRA “shell”.
Inheriting a Traditional IRA from Your Spouse
You can roll over this inherited IRA into an IRA you already have and the earnings will continue growing tax-deferred. You’ll pay income taxes on any distributions you take but, if you’re over age 59 ½, you won’t owe the 10% tax penalty for early withdrawals.
People typically make two mistakes when inheriting IRAs: They either forget to take the RMDs, or, with traditional IRAs, they take a lump sum distribution in a high-income year. The first mistake results in a 50% penalty on the amount taken below the RMD. The second may cause the entire distribution amount to be taxed at a higher rate than necessary. For individuals inheriting an IRA, understanding your options as well as the requirements and potential liabilities of those options is essential to making an informed election and to maximizing your potential benefits.
Sustainable Investing the Funds
On top of all of this, you, the inheritor, can make the decision to utilize the funds in a sustainable and responsible manner by divesting of any funds that are held in companies that do not align with your values. Ask your financial advisor if they could please utilize ESG screens on the holdings or at the least divest of fossil fuel companies and assault weapon manufacturers. For those who are lucky enough to inherit money from a relative, one would think that the logical and moral thing to do is to at least be sure these funds are being invested in a sustainably responsible manner.