Discretionary Wealth: Leveraging a Self-Directed Inherited IRA for Aggressive Growth
Do you know that feeling when an unexpected windfall comes your way? Perhaps an inheritance from a loved one. It's a feeling of gratitude and excitement mixed with a bit of uncertainty about what to do next. If you find yourself the beneficiary of an inherited IRA, I've got some insights that could turn that uncertainty into a significant wealth-building opportunity.
An inherited self-directed IRA, also known as an inherited SDIRA, is a type of retirement account that allows you to invest the assets you've inherited from someone else's IRA in a wide range of alternative investments beyond stocks, bonds, and mutual funds.
When you inherit an IRA from a loved one, you can transfer those retirement assets into an inherited IRA account. With a traditional inherited IRA, your investment options are limited to publicly traded securities and funds, but you can still self-direct an inherited IRA to give yourself more options.
An inherited SDIRA gives you much more flexibility and control over how you invest those inherited assets. As the name implies, you can self-direct the investments within the account, opening up opportunities to invest in alternative assets such as real estate, private lending, tax liens, and more.
What Is a Self-Directed Inherited IRA?
An inherited IRA, also known as a beneficiary IRA, is a type of retirement account created when someone inherits the assets from a deceased person's individual retirement account (IRA).
When the original IRA owner passes away, the remaining IRA assets are not just liquidated and distributed to their beneficiaries. Instead, the beneficiaries can transfer the inherited IRA money directly into an inherited IRA in their own name.
The benefit of an inherited IRA is that it enables the beneficiary to take distributions gradually over a specified period of time rather than a full lump-sum distribution, which could push them into a higher tax bracket.
Inherited IRA rules regarding RMDs, tax treatment of distributions, and other provisions differ from those of personal IRAs established with one's own contributions. Proper handling and withdrawal scheduling for an inherited IRA are essential to avoid costly penalties.
Overall, an inherited IRA provides flexibility in managing a legacy inheritance while allowing the beneficiary to benefit from the tax-deferred growth potential initially intended for retirement savings.
The Unexpected Inheritance Advantage
Inheriting an IRA is often an emotionally complex experience. On one hand, you're deeply grateful to receive such a generous financial legacy from a loved one. But on the other, the inheritance itself is a sobering reminder of your loss and the circumstances that enabled it to pass to you. Navigating those bittersweet feelings is never easy.
However, please consider how the unexpectedness of an inherited IRA is precisely what unlocks its potential as a powerful wealth-building tool when invested through an SDIRA.
With the retirement accounts you've built up through decades of diligent saving and investing, you've always had to balance competing financial priorities. Funding your own SDIRA while paying mortgages, raising kids, and running a business is an ongoing juggling act made more complicated by annual contribution limits and other restrictions.
However, an inherited IRA from a departed family member represents a sudden influx of funds you likely never originally earmarked or planned around when building your retirement strategy. It's a bonus investment opportunity that comes to you without those same regular constraints.
Because you were not relying on or building plans around this money from the start, you have the luxury of treating it as a discretionary, almost "fun money" investment that can be deployed much more aggressively than your core retirement holdings. Want to invest in that bold new project? Roll the dice on an exciting private startup? Snap up an undervalued rental property to rehab? An inherited SDIRA allows you to get creative and speculative with assets that may be too illiquid or volatile for your primary retirement funds.
So, while the inheritance itself may be bittersweet, the flexibility to invest it opportunistically through an SDIRA turns that unexpected legacy into a unique wealth-compounding tool that can pay dividends for years or even generations to come.
Required Minimum Distributions (RMD) Calculations
Required Minimum Distributions are the minimum amount of money that must be withdrawn annually from inherited IRAs. The distribution rules depend on a couple of factors — the relationship to the original owner and the date of inheritance.
Before the SECURE Act was established in December 2019, beneficiaries could “stretch” their distributions over their life expectancy. However, beginning in 2020, RMDs for non-spouses generally need to be taken over a 10-year period, fully liquidating the account at the end of ten years. If you do not take the RMDs, you may be subject to an “excess accumulation penalty”.
Depending on your relationship with the deceased, different distribution options are available for inherited IRAs. However, the options can be confusing, so always check with your tax professional or financial advisor.
Spouse
When it comes to inherited IRAs, spouses have the most flexible distribution options compared to non-spousal beneficiaries. Here are some key options for spouses who inherit an IRA if they want to continue growing their funds in an IRA:
Treat the IRA as Your Own
If you are the spouse and the sole primary beneficiary of the IRA, you can opt to treat the inherited IRA as your own. This allows you to transfer the cash or assets into your existing IRA or into a new IRA in your name. Even if the inherited IRA was not self-directed, you can turn it into an SDIRA, giving you more investment options. If you treat the IRA as your own, you can continue to add funds to it.
The type of IRA will need to remain the same. For example, a traditional IRA cannot be rolled into a Roth IRA. However, after the assets are rolled over, you can convert the assets into a Roth IRA using the Roth conversion process.
If you choose this method, you will now follow the rules of your IRA, not of the inherited account.
Assume the Inherited IRA
With this option, you transfer the assets into an Inherited IRA. If the original account owner was required to take RMDs and did not do so in the year of their death, you will need to take the RMD for the year. The spouse may need to continue with RMDs, which are calculated on the spouse’s life expectancy using the IRS’ Uniform Life Expectancy Table.
If the original IRA owner was not taking RMDs, the spouse will only need to do so at the end of the year the original owner would have reached their required beginning date (RBD).
An Inherited IRA: 10-year Method
If you open an inherited IRA in your name using the 10-year method, you will not be required to make RMDs each year. However, you must liquidate the account within ten years of the original account holder’s death. You are taxed on each distribution at your current income tax rate. You do not need to withdraw funds each year, but again, the account must be closed in ten years.
Non-Spouse Beneficiary
Non-spousal IRAs inherited after the start of 2020 do not have the same flexibility as when a spouse inherits an IRA.
If the account holder died before the start of their RMDs, you can choose to:
Open an inherited IRA using the life expectancy method. You will be required to begin RMDs no later than 12/31 of the year after the death. The amount is determined using the Uniform Life Expectancy Table. You will be taxed on all RMD distributions at your current tax rate.
Open an inherited IRA: 10-year method. If you use the 10-year method, you are not required to take a distribution each year, but the account must be depleted within 10 years. Again, all distributions are taxed at your current income tax rate.
If the account holder died after beginning RMDs, current IRS regulations state that you must continue taking RMDs and draw the account down by the end of the 10th year. To add to the confusion, the IRS removed the requirements for annual payments in 2021, 2022, 2023, and 2024. What will happen in future years remains to be seen.
Whatever option you choose, you can then move the funds into the new account and set it up as an SDIRA You can no longer contribute to the plan, but the funds can continue to grow as they are invested.
There are also some different options for “eligible beneficiaries,” which could include minor children, disabled, or chronically ill. With all the complexities and uncertainties surrounding the IRS regulations on distributions, check with your tax professional. You can also get more information from IRS publication 590-B.
SDIRAs and RMDs
You need to be particularly careful when dealing with an inherited Self-Directed IRA (SDIRA) and Required Minimum Distributions (RMDs) for a few key reasons:
Illiquid Investments: One of the main advantages of SDIRAs is the ability to invest in alternative, non-traditional assets like real estate, private equity, promissory notes, etc. However, these investments can be illiquid compared to publicly traded securities. When it comes time to take RMDs, you may be unable to quickly sell off portions of these illiquid assets to raise the cash needed to satisfy the RMD amount.
Income Requirements: With a traditional IRA investing in stocks/bonds/funds, you can often use the income generated within the account (dividends, interest, capital gains) to fund RMDs. With an SDIRA's alternative investments, there may not be consistent income streams available, making it more challenging to produce the cash for RMDs without requiring asset liquidation.
Asset Valuations: To calculate the annual RMD amount precisely, you need an accurate valuation of the SDIRA's alternative assets as of December 31st each year. However, valuing illiquid assets like real estate can be complex and subjective compared to the mark-to-market method for public securities.
Tax Implications Failure to take full RMDs from an inherited IRA can result in severe tax penalties of 25% of the amount not withdrawn in addition to the ordinary income taxes owed. With higher dollar amounts often involved with inherited IRAs, these penalties can be quite punishing.
Let’s look at a potential scenario:
Imagine you inherit an IRA and decide to roll it over to an SDIRA. You invest a significant portion in a promising piece of real estate. The property has excellent long-term potential, but selling it quickly may not be an option. Now, when your RMD comes due, you might be stuck. You can't access the cash tied up in the real estate, and failing to meet your RMD results in a hefty penalty from the IRS.
To avoid this liquidity trap, consider your asset allocation within the SDIRA. While alternative investments offer exciting possibilities, ensure you have enough readily available assets (like stocks or bonds) to cover your anticipated RMDs in the coming years.
Always consider the investment timeframe for your chosen assets. If a real estate venture has a high potential return but a long-term exit strategy, balance it with investments that offer quicker access to cash for RMDs.
It's crucial to plan ahead and structure the SDIRA's alternative investments to generate income explicitly for RMD purposes. It is highly recommended that you work closely with qualified SDIRA custodians, administrators, CPAs, and financial advisors to remain compliant while maximizing the benefits of an inherited SDIRA.
How Chicago Trust Administration Services Can Help
At Chicago Trust Administration Services, we specialize in providing comprehensive custodial and administrative services for self-directed IRAs, including inherited IRAs. Our deep expertise in alternative investment accounts allows us to guide you through the complexities of managing these unique retirement vehicles, ensuring full compliance with IRS regulations while maximizing their wealth-building potential.
To see how we can help, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com. Don’t let the opportunities presented by an inherited IRA pass you by.
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*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.