Inheriting Your IRA: The Phone Call That Could Result in Significantly Higher Taxes for Your Kids
**The family in this story is not an actual client. It’s a composite of situations for the purpose of illustrating a strategy. The figures used below are for illustrative purposes only and are based on current tax law, which is subject to change. Actual tax outcomes will vary based on personal circumstances.
David and Susan had done everything right.
Over the course of their careers, they lived below their means, maxed out their 401(k) contributions year after year, and made disciplined investment decisions. By the time David retired at 64, they had accumulated just over $2 million in his 401(k), a number that represented decades of patience and focus.
David named Susan as his primary beneficiary on his IRA which now held the rolled over balances from his 401(k), and their twin sons Michael and Steve evenly as the contingent beneficiaries. Everything was in order.
Sadly, three years after David retired, he passed away unexpectedly, and Susan transferred his IRA into her own IRA without paying any taxes.
Key point: Spouses have that option. Non-spouse beneficiaries, like Michael and Steve, do not.
Four years later, Michael and Steve’s mother Susan passed away as well.
Michael, a 48-year-old engineer earning $200,000 per year, was always the most diligent of their sons so he called the investment firm of his mother’s IRA to notify them of his mother’s passing. The representative on the other end of the line was sympathetic and professional. “We’re so sorry for your loss. We’ll send you and Steve distribution request forms. Just sign your form, return it with a certified death certificate, and we’ll have a check to you within seven to ten business days.”
Sounds simple enough, right?
Michael signed his form and within two weeks, a check for a smaller amount than he was anticipating arrived in his mailbox.
And just like that, with one phone call and one signature, Michael incurred federal income taxes of $336,000!
How Does This Happen?
An IRA, whether it’s a Traditional IRA, a 401(k), or a rolled-over pension, is considered a tax-deferred account. The money inside was never taxed when it went in, and it has never been taxed as it grew. The IRS has been patiently waiting the entire time.
The moment that money comes out, it is treated as ordinary income in the year it’s received.
So, when Michael received his $1,000,000 portion from his mother’s IRA on top of his household’s $200,000 in wages, his total taxable income for that year became $1,200,000.
At that level, a large portion of the IRA distribution was taxed at the 35% and 37% federal brackets. The result: $336,020 in federal income taxes on the IRA alone — an effective rate of 33.6% on the full $1,000,000.
And this doesn’t even take into consideration state taxes which, depending on what state you live in, may be significantly more. In Massachusetts, for example, Michael’s total income tax bill from inheriting his mother’s IRA climbed to over $400,000 given base tax rate of 5% plus the additional 4% tax on total income over $1 million.
In one year. With one signature.
There Was Another Option
What the representative on the phone did not tell Michael, and what could happen to any unsuspecting and discerning individual inheriting an IRA, is that there was another option.
Rather than taking a lump sum distribution, Michael could have transferred his share into what’s called an Inherited IRA, keeping his mother as the deceased owner and himself as the beneficiary. The money would have stayed invested, continuing to grow tax-deferred, and Michael would have had up to ten years to take distributions on his terms.
This is the option that the SECURE Act of 2020 now governs for most non-spouse beneficiaries. Prior to 2020, beneficiaries could stretch distributions, and the tax burden, over their entire lifetime. Today, all funds must be withdrawn by the end of the tenth year following the original owner’s death.
Because Michael’s mother Susan had not started taking her own required minimum distributions (RMD) from her IRA, Michael could take as little or as much as he chooses each year, as long as the account is fully depleted by year 10. This would allow him to strategically plan when it was most advantageous to withdraw funds from a tax perspective.
What the Numbers Actually Look Like
Let’s compare both scenarios side by side for Michael.
In Scenario One, the lump sum, Michael adds $1,000,000 to his $200,000 household income in a single year, triggering $336,020 in federal taxes on the IRA distribution alone, at an effective rate of 33.6%.
In Scenario Two, using the Inherited IRA and spreading equal $100,000 distributions over ten years, Michael would have added $100,000 to his $200,000 household income each year, for a total of $300,000 annually. The federal tax on the IRA portion each year is approximately $23,979, for a total over 10 years of $239,790, an effective rate of just 24%.
Under these assumptions, using the Inherited IRA option, Michael could potentially reduce federal taxes by approximately $96,230, and that doesn’t account for the additional growth that could potentially occur inside the Inherited IRA during those 10 years while he’s drawing it down gradually.
That’s not a loophole. That’s not a complicated tax strategy. That’s simply understanding your options before you make an irreversible decision.
Make Your Children Aware Now
Unfortunately, you can’t make this decision for your children after you’re gone. The Inherited IRA option must be exercised by your beneficiaries, and it must be set up correctly within a specific timeframe after your passing.
The most important thing you can do today is make sure your children and grandchildren know this option exists before they make that phone call.
Your IRA beneficiary designations should be reviewed and updated regularly. Your named beneficiary supersedes whatever your will says, which means an outdated form can undo years of careful planning in an instant.
Your children should understand the 10-year rule and begin thinking now about how they would manage distributions strategically — considering their own income tax brackets, their financial needs, and the possibility of higher tax rates in the future.
Avert Unintended Consequences
You have spent your entire adult life building what you have. You stayed disciplined when markets were frightening and temptations were everywhere. Your IRA didn’t happen by accident; it happened because of decades of smart decisions.
Advance planning can help reduce the risk of unintended tax consequences.
We’re here to help you think through your IRA beneficiary strategy and what your heirs will face when they inherit it.
Jack Phelps
Managing Partner / Financial Advisor