Recently I’ve suggested to two different people something they might want to consider regarding an IRA they have inherited from a parent. While this strategy seems pretty straightforward to me, it was very much a surprise to them so I thought it might be worth a quick blog post (well, “quick” for me :-). This is especially relevant right now because Boomers are aging and we are about to experience the greatest generational wealth transfer ever. (I’m going to use the general term “IRA” in this post for convenience, but this applies to inherited 401ks, 403bs, and 457bs as well.)
Note: The IRS rules are still in flux and have been delayed several times, so the final regulations may end up being different. This is my best understanding right now of what the rules will look like. And, as always, I’m not a CPA or tax attorney, so please don’t take this as tax advice. Also, this post is discussing IRAs typically inherited from your parents or other non-spouse relatives, there are different rules for inherited IRAs from your spouse and for some eligible designated beneficiaries.
The Secure Act (1.0, passed in 2019) changed the rules around inherited IRAs (and 401ks, 403bs, 457s). Previously, inherited IRAs could be stretched over the lifetime of the beneficiary (not surprisingly, known as a “stretch” IRA), which was a very helpful technique to manage taxes and grow your investments. It was so helpful, however, that people really started taking advantage of it (especially wealthy folks) and using it in ways that it was never intended (perfectly legal, but not the intent of the law). The Secure Act has now changed that (technically, only for folks who die after 2019) so that you have to take out the entire balance of the IRA within 10 years of the death of the original IRA owner. In addition, some folks will be subject to required minimum distributions (RMDs) during those 10 years. I’ll look at inherited traditional (pre-tax) IRAs and Roth IRAs separately.
Inherited Traditional (pre-tax) IRAs (401ks/403bs/457bs)
Inherited pre-tax accounts are the ones where the elimination of the lifetime stretch is the most consequential in terms of taxes. This is because the beneficiary has to pay taxes on the withdrawals when they are made and, depending on the balance in the inherited account and the rest of their tax situation, it may even push them into a higher tax bracket. When the Secure Act first passed, most people assumed that you could take those withdrawals in any amount you wanted over those ten years, as long as you took the entire amount within ten years (with lots of people planning on letting it sit until just before the 10 years were up and then withdrawing all of it). But the IRS has issued proposed guidance that not only do you have to take the entire balance out within 10 years, but if the original IRA owner (the deceased) had already started taking RMDs, you also have to take RMDs each year based on your age (using the RMD tables in pub 590b, and then in year 10 take whatever the remaining balance is). This can cause some headaches in terms of tax planning and tax optimization. (To be sure, this is a very good “problem” to have, but it’s still something you’d like to manage.) Folks have to be aware of the rules or they could end up paying significant penalties if they don’t withdraw enough each year.
What many people would love to be able to do is simply add their inherited IRAs to their own IRAs and not worry about this until retirement. Unfortunately, that’s not allowed. Yet, for many people (especially educators), there actually is a sidedoor way to (effectively) do this (apologies to the backdoor IRA for riffing on its name). The people I’ve had conversations with are still working, which is a critical piece of this, as having access to employer-based tax-advantaged accounts is necessary to implement this strategy at scale. They are also both educators, which is extra helpful because they not only have access to the 401k/403b “bucket”, but a second 457b bucket. This means that they potentially can contribute twice as much ($45,000 if under age 50, $60,000 if over 50; 2023 limits) as non-educators can to employer-based plans (plus, of course, they still have their personal IRA). The dual buckets have been true for a while, but most educators don’t make enough to be able to take advantage of both of them and still pay the bills. Enter the inherited IRA.
The strategy is to essentially “shift” the money from the inherited IRA to a pre-tax 401k/403b and/or 457b and/or traditional IRA and/or HSA. Again, you are not allowed to simply transfer the money from the inherited IRA to any of those accounts. But the strategy I suggested to these folks is pretty simple. You withdraw money from the inherited IRA (making sure it’s at least as much as the RMD, and perhaps even more). Then you use that money to live off of and then contribute most or all of your paycheck to your pre-tax 401k/403b/457b/HSA (and IRA if necessary, although you typically can’t do that from your paycheck). Essentially, you are transferring the inherited IRA into your pre-tax retirement accounts, but you’re not doing it directly (which, again, isn’t allowed). And, if you have a spouse, you can do this with their paycheck and employer-based retirement plans as well if necessary (giving you another $22,500 if your spouse is under 50, $45,000 if over 50; or twice that if they are also an educator). It’s up to you whether to withdraw from the inherited IRA throughout the year as needed (possibly stretching the tax-free growth a bit longer), or just to do it as a lump-sum for the year all at once.
Perhaps the reason this seems surprising to people is that it’s hard for them to get their head around contributing as much as 100% of their paycheck to their retirement accounts (and getting a paycheck of $0 or very little). But money is fungible, it doesn’t matter whether you pay the bills with money from your paycheck or money from your inherited IRA, as long as the bills get paid. Now there are a couple of things to watch out for.
- You need to find out if your payroll system is smart enough to stop your contributions when you hit the maximum limit for the year in the various accounts (401k/403b bucket, 457b bucket, HSA). If not, you’ll need to monitor and manually adjust your contribution when you approach the limit.
- Even if the software handles it (it should), you also need to pay attention because it’s very possible you will contribute 100% of your paycheck to your 401k/403b bucket until it maxes out part way through the year, then need to manually switch your payroll preferences to contributing 100% to your 457b for the rest of the year (or vice-versa).
- If you do contribute 100% of your paycheck (or close to it) to a pre-tax account, your employer won’t withhold any federal or state taxes from your paycheck (because from their perspective, you won’t have any taxable income). But because you are withdrawing from an inherited IRA, that will then become taxable income. So you will want to make sure to have both federal and state taxes withheld from your inherited IRA withdrawal (or perhaps force withholding from your paycheck through your withholding settings). It shouldn’t be that hard to figure out, simply estimate the total withholding you would normally have from your paycheck over the course of the year and have that withheld when you make the IRA withdrawal.
The exact numbers, of course, will depend on the balance of your inherited IRA(s), your total income (you have to have earned income to contribute to 401k/403b/457/IRA, and you won’t be able to contribute more than your paycheck), and various other factors. But, for many folks, they likely will be able to funnel the entire inherited IRA balance into their pre-tax accounts over the course of those ten years, while simultaneously satisfying the RMD requirements. You will still pay the same amount of taxes you normally would have without the inherited IRA, but will effectively move the inherited IRA into your own pre-tax account. (To be clear, you will ultimately owe taxes when you withdraw from these pre-tax accounts in retirement, but that might still be many years of tax-deferred growth.)
This is great for those who want to pay the same amount of taxes now and supercharge their pre-tax retirement accounts. But there’s another variation that is likely to be attractive to some folks, which is to instead supercharge your Roth accounts. This is again especially true for many educators who have a defined benefit pension, because they will likely be in at least a medium tax bracket in retirement (due to their defined benefit pension being taxable), which makes Roths more attractive (as well as providing tax-flexibility for withdrawals in retirement).
For this strategy, you likely will want to try to “fill” your current tax bracket with withdrawals from the inherited IRA, use those withdrawals to live on, and this time contribute 100% (or whatever) of your paycheck to the Roth versions of your 401k/403b and 457b buckets. Many educators are in the 22% marginal tax bracket at the federal level, which in 2023 goes up to $95,375 for single and $190,750 for married filing jointly. So, for example, if a married couple normally has taxable income of $130,000, they then have $60,750 left in order to “fill” their 22% bracket (as we don’t want to have any money taxed at the 24% level if possible). Yes, you’ll pay more taxes now with this variation than the previous one, but you are locking in that 22% tax rate on the withdrawal. This is, in effect, a Roth conversion strategy. (And this is especially timely if you can do this right now as the current tax rates are scheduled to expire at the end of 2025, so the tax rate on income – including traditional IRA withdrawals – will be going up if Congress doesn’t change anything.)
A third variation, of course, would be to do some combination of both of those, putting some in pre-tax and some in Roth. For many educators who want to do this combination, it would make sense to use the 457b for pre-tax (for easier access to the money if you retire before age 59.5) and use the 401k/403b bucket for Roth. No matter which variation you end up with, it’s important to do the calculations on the tax withholding carefully so you don’t end up owing penalties when you file your taxes.
Inherited Roth (Post-tax) IRAs (401ks/403bs/457bs)
Inherited Roth IRAs aren’t quite as big of an issue, as there are no taxes due on withdrawals. While it’s a bummer that you can no longer stretch the Roth IRA over your lifetime, ten years is nothing to sneeze at. Unlike your own Roth IRA, inherited Roth IRAs are subject to RMDs as well as the 10-year rule. (Note: There is currently much disagreement about whether inherited Roth IRAs are indeed subject to RMDs or whether you can simply keep it in there for up to ten years and then withdraw it. For the purposes of this post, it doesn’t matter that much.) While you don’t have the tax implications from the RMDs from Roth IRAs to worry about (as withdrawals are tax free), you may still want use these RMDs (or larger-than-RMDs) to supercharge your 401k/403b/457b/HSA/IRA contributions. You have the same three variations open to you (pre-tax, Roth, combination), but without the complication of the tax liability from the withdrawal from the inherited IRA. You could live off the withdrawals from the inherited Roth and direct your paycheck into pre-tax, Roth, or a combination. Money is fungible and it’s the same kind of shift as above.
So, is this the greatest thing since sliced bread (or stretch IRAs)? No. But it can still be a very useful strategy for essentially transferring an inherited IRA into your own retirement accounts (traditional, Roth, or a combination) while optimizing the taxes you owe now and in the future.