Author Topic: Is it always bad to cash out an inherited IRA?  (Read 2281 times)

quelinda

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Is it always bad to cash out an inherited IRA?
« on: September 24, 2018, 04:20:17 PM »
My mother recently passed away. She had several IRAs and had designated me and my sisters the beneficiaries -- each of us will receive about $95,000.

I am considering cashing out my share, which I know means I will owe taxes on this amount immediately. But here are my reasons for considering doing it anyway:

*Although we are on track to have my DH retire at about age 60 (he is currently 53 & I'm 47 and a SAHM), we don't really have a large emergency fund. I know there are varying schools of thought about this, but I personally would feel much better if we had a really beefy emergency fund.

*We have a lot of expensive, necessary repairs that need to be done on our house, including a new roof, some foundation work, and a fireplace conversion. We've put these off for years and it would be so great to get them done.

*I would want to put this money into a very low-yield, low-risk investment if we were to keep it as an inherited IRA, so it wouldn't grow that much anyway. Right now DH's 401K (our only investment, besides my very small Roth IRA & an HSA) is entirely in a Vanguard stock index fund. I know there are varying schools of thought on *that* as well.

*If I kept it as an inherited IRA, I would have to receive RMDs and pay taxes on the money at that time anyway. I would honestly rather not fiddle around with RMDs. I think this is kind of my main issue, honestly. I realize the inherited IRA could be used as an emergency fund...but I'd rather have it in a money market account.

The rest of the inheritance would allow us to pay off our mortgage, and with a beefy emergency fund and enough money to take care of household repairs (and new cars when needed), we would have the cash flow to really plow money back into investments -- but on our terms.

Am I making any sense at all? Of course the investment companies are telling me that most people don't do this because of the tax consequences, but they have have a vested interest in my NOT cashing out.
« Last Edit: September 24, 2018, 04:23:38 PM by quelinda »

not_a_trex

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Re: Is it always bad to cash out an inherited IRA?
« Reply #1 on: September 24, 2018, 04:38:56 PM »
I would keep the IRA.

I think I would stop contributing to your other retirement accounts (after the match) before cashing in on the IRA in order to fill up the emergency fund. You would save you the 10% penalty you would pay otherwise and potentially end up with more money in the long run since you're front loading the investment.

There's a bigger problem at hand though. How did you end up without an emergency fund or money for house repairs in the first place?

seattlecyclone

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Re: Is it always bad to cash out an inherited IRA?
« Reply #2 on: September 24, 2018, 04:47:34 PM »
In general, you keep your taxes the lowest by keeping your income as even as possible from year to year. That means you'll generally get to keep more of your inheritance if you spread out the withdrawals over several years instead of taking it all at once.

Quote
*Although we are on track to have my DH retire at about age 60 (he is currently 53 & I'm 47 and a SAHM), we don't really have a large emergency fund. I know there are varying schools of thought about this, but I personally would feel much better if we had a really beefy emergency fund.

You can withdraw from the IRA whenever you like. Why take the tax hit now, rather than when an "emergency" happens?

Quote
*We have a lot of expensive, necessary repairs that need to be done on our house, including a new roof, some foundation work, and a fireplace conversion. We've put these off for years and it would be so great to get them done.

This seems like a fine reason to withdraw some of the funds. How much do you expect these repairs to cost? They sound like they should be cheaper than the entire balance of the IRA. As at least some portion of the work sounds like it isn't very urgent, you may benefit from splitting the withdrawals over two tax years. Again, keeping your income as even as possible from year to year is the way to keep the most of your inheritance.

Quote
*I would want to put this money into a very low-yield, low-risk investment if we were to keep it as an inherited IRA, so it wouldn't grow that much anyway. Right now DH's 401K (our only investment, besides my very small Roth IRA & an HSA) is entirely in a Vanguard stock index fund. I know there are varying schools of thought on *that* as well.

If you haven't yet done so, I would suggest writing an investment policy statement that will help you govern your investment choices. I certainly understand the desire to not have 100% of your money in the stock market, to help moderate swings in stock prices during your withdrawal years. To keep your investments working for you over the long term you probably still do want the majority of your overall portfolio in stocks though.

Quote
*If I kept it as an inherited IRA, I would have to receive RMDs and pay taxes on the money at that time anyway. I would honestly rather not fiddle around with RMDs. I think this is kind of my main issue, honestly. I realize the inherited IRA could be used as an emergency fund...but I'd rather have it in a money market account.

These calculations aren't too bad. The first year, you look up your age in a table. Divide 1 by the number shown to see what fraction of the account you need to withdraw. Each year after that, you add 1 to the divisor. The amount of tax you could save by doing this seems rather high in comparison to the effort required.

As to the money market idea, the decision to put some of your savings in a money market fund is not incompatible with leaving it in the IRA for now. The IRA is just a bucket that you can put most any investment into, including money market funds.

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The rest of the inheritance would allow us to pay off our mortgage, and with a beefy emergency fund and enough money to take care of household repairs (and new cars when needed), we would have the cash flow to really plow money back into investments -- but on our terms.

Tax deferral is a valuable thing. By all means, withdraw some of the money to pay for things you need and have been putting off, but pulling a bunch of money from one tax shelter just to put it in another is a waste of a good opportunity to defer taxes.

Quote
Am I making any sense at all? Of course the investment companies are telling me that most people don't do this because of the tax consequences, but they have have a vested interest in my NOT cashing out.

Your first step should be to move the account to a company that doesn't stand to earn a bunch of money from your business, such as Vanguard. Low-fee index funds are the way to go, not expensive funds pitched by an investment advisor/salesman.

geekette

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Re: Is it always bad to cash out an inherited IRA?
« Reply #3 on: September 24, 2018, 04:52:32 PM »
We went through something similar with my DH's father.  Make SURE your inherited IRA is separated from your sisters and someone (either your mother or you) takes the RMD by the end of the year.  The bank that was holding my FIL's separated it and cut a check for the estate for the RMD.

There's no 10% penalty for an inherited IRA, but you would have to pay ordinary income taxes on that whole $95k, which could be a lot on top of your regular income.

The RMD's are done by the bank/brokerage, so it's not fiddly.  You get a check and a 1099-R for your taxes.

The RMD is a minimum.  You can withdraw more if needed, but again, you'd pay taxes on it.

SeattleCPA

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Re: Is it always bad to cash out an inherited IRA?
« Reply #4 on: September 24, 2018, 05:04:53 PM »
Here's a blog post I did that summarizes the typical best practices for an inherited IRA. (The  general rule is stretch and then stuff money you RMD into your own IRAs or 401(k)s.)

https://evergreensmallbusiness.com/right-way-to-handle-inherited-ira-accounts/

But I guess the one other thing to say is this: It seems kinda problematic if you have housing expenses that you can only finally pay by using an inheritance.

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #5 on: September 24, 2018, 05:39:42 PM »
We went through something similar with my DH's father.  Make SURE your inherited IRA is separated from your sisters and someone (either your mother or you) takes the RMD by the end of the year.  The bank that was holding my FIL's separated it and cut a check for the estate for the RMD.

There's no 10% penalty for an inherited IRA, but you would have to pay ordinary income taxes on that whole $95k, which could be a lot on top of your regular income.

The RMD's are done by the bank/brokerage, so it's not fiddly.  You get a check and a 1099-R for your taxes.

The RMD is a minimum.  You can withdraw more if needed, but again, you'd pay taxes on it.

Thank you, this confirms what I've learned so far. My mother already took her RMD from one of the investment companies but not the other, and it seems like they are aware of how to handle it (the contact person said my sisters and I would each need to take 1/3 of the RMD by the end of the year).

I suppose my questions really should be:

*How difficult/slow is it to get money from the IRAs when we need it?

*And is there really a huge difference in the taxes I'd pay on the money if I cash it all out now vs. cashing it all out over a period of years? (Is there an online calculator I could use to figure this out?)

Also, regarding the problematic nature of our not having an emergency fund -- we've been maxing out my DH's 401K & his HSA instead of building up an emergency fund. We have no debt besides our mortgage. If we *had* to, we could cash out some of the HSA because I have a giant stack of medical bills we've paid out of pocket, and we could suspend contributions to the 401K. We also have about $5,000 in our checking account at all times. So while we don't have the emergency fund I'd like, and we were going to have to figure out how to pay for the home repairs at some point, we're not without options. But as I said, we will be able to pay off our mortgage and should be in a much better position after the estate is settled.

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #6 on: September 24, 2018, 05:41:09 PM »
Here's a blog post I did that summarizes the typical best practices for an inherited IRA. (The  general rule is stretch and then stuff money you RMD into your own IRAs or 401(k)s.)

https://evergreensmallbusiness.com/right-way-to-handle-inherited-ira-accounts/

But I guess the one other thing to say is this: It seems kinda problematic if you have housing expenses that you can only finally pay by using an inheritance.

Thanks for the link -- I've been trying to read up on this as much as I can. I wish it were something my mom had discussed with us before she passed away.

Dee18

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Re: Is it always bad to cash out an inherited IRA?
« Reply #7 on: September 24, 2018, 05:53:14 PM »
This is not an all or nothing decision.  You can cash out some and leave the rest in.  And cash out more if you need it for an emergency.  I inherited a small IRA when my father died.  I get about $500 a year.  Every time I receive it I think about what a nice gift it is from my dad. Fidelity withholds the appropriate tax. I only have to fill out one additional line on my 1040.

geekette

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Re: Is it always bad to cash out an inherited IRA?
« Reply #8 on: September 24, 2018, 06:06:33 PM »
<snip>My mother already took her RMD from one of the investment companies but not the other, and it seems like they are aware of how to handle it (the contact person said my sisters and I would each need to take 1/3 of the RMD by the end of the year).

I suppose my questions really should be:

*How difficult/slow is it to get money from the IRAs when we need it?

*And is there really a huge difference in the taxes I'd pay on the money if I cash it all out now vs. cashing it all out over a period of years? (Is there an online calculator I could use to figure this out?)
<snip>
I'm curious about this "1/3 of the RMD".  I believe it should be either your mother's RMD, split up via however the estate is split (which may be the 1/3 you're talking about), or you split the IRA per the will and you take your RMD based on your own birthdate before the end of the year.

As for getting the money, we just went to the bank, they filled out a form, and cut the check.  If it's online, it will probably take a couple days to transfer.

As for the increase in taxes, here are some tax tables.  Add $95k to what you expect your taxable income to be this year.  You'd probably do better to spread it out.

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #9 on: September 24, 2018, 06:36:12 PM »
<snip>My mother already took her RMD from one of the investment companies but not the other, and it seems like they are aware of how to handle it (the contact person said my sisters and I would each need to take 1/3 of the RMD by the end of the year).

I suppose my questions really should be:

*How difficult/slow is it to get money from the IRAs when we need it?

*And is there really a huge difference in the taxes I'd pay on the money if I cash it all out now vs. cashing it all out over a period of years? (Is there an online calculator I could use to figure this out?)
<snip>
I'm curious about this "1/3 of the RMD".  I believe it should be either your mother's RMD, split up via however the estate is split (which may be the 1/3 you're talking about), or you split the IRA per the will and you take your RMD based on your own birthdate before the end of the year.

As for getting the money, we just went to the bank, they filled out a form, and cut the check.  If it's online, it will probably take a couple days to transfer.

As for the increase in taxes, here are some tax tables.  Add $95k to what you expect your taxable income to be this year.  You'd probably do better to spread it out.

The IRAs are the only things out of the trust. The trust is divided among four people, but the IRAs are divided among the three of us.

The way it was explained to me is that because my mother did not take her RMD for the year, we need to take that amount out of the IRA, divided up between the three beneficiaries, before the end of the year. After that, we take the RMDs annually based on our own birthdates. The amount my mother was supposed to have taken for this calendar year is a separate issue from our RMDs.

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #10 on: September 27, 2018, 01:06:16 PM »
The input you all have given me has made me do more thinking/reading, and Iíve decided to keep the money in an inherited IRA. Thank you!
« Last Edit: September 27, 2018, 01:09:24 PM by quelinda »

Frankies Girl

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Re: Is it always bad to cash out an inherited IRA?
« Reply #11 on: September 27, 2018, 01:41:17 PM »
I received an IRA from when my dad died, and I actually think it's better to leave as much money in there, invested in funds that fit your AA, and take your RMDs as needed with any additional money you need withdraw on an "as needed" basis.

Inherited IRAs (iIRAs) are kind of a nifty hybrid account. They are tax deferred as long as they originally were a traditional/rollover (not a Roth, but you wouldn't need to take RMDs from a Roth anyway).

So you have a HUGE tax deferred account, no penalties to pull a single dollar out at any time (unlike your own personal IRAs that will assess 10% if you pull before 59.5), and you can control their investments yourself.

You can invest this in your bond allocation as per your AA if you worry about it growing too large, but having it top itself up isn't a terrible thing. I've had mine for just around 5 years now, and I've pulled about 2/3 of our yearly expenses from it, and it just keeps re-leveling. As long as you take the RMD, you really can do whatever you like with it at any time. Don't underestimate the power of having a tax deferred account that lets you withdraw any time, and the only taxes you'd pay are if you go up in the taxable bracket anyway due to your earned income when combined with ordinary income and things like dividends/cap gains thrown off in a taxable... so sure it may push you up into a higher taxable bracket, but you only pay on the amount over. And you can control the amounts other than the RMDs anyway.

And it's super easy to take more out whenever. I do mine through Fidelity and it is is a matter of deciding what I want to sell off to get the cash, then put in the order, wait for the cash to settle and then set up a transfer to a linked account.

ILikeDividends

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Re: Is it always bad to cash out an inherited IRA?
« Reply #12 on: September 27, 2018, 05:05:41 PM »
I am considering cashing out my share, which I know means I will owe taxes on this amount immediately. But here are my reasons for considering doing it anyway:
It's a little unclear from your OP as to whether this is literally an inherited IRA
(meaning an IRA in your name and under your own tax id) versus an IRA held in trust under the trust's tax id, which you and your sisters are the beneficiaries of.  The distinction is critical.

You want to be very careful in how (and possibly when) you pull money out of an IRA held in a trust.  And certainly how you account for that during tax-time.  That trust is a separate legal entity having a different tax id than your mother's social security number (called an EIN for legal entities).

This link shows tax brackets for individuals, estates, and trusts.
https://www.edwardjones.com/images/OPR-9806B-A-2018-federal-tax-brackets.pdf

Look on the first page, at the tax brackets for estates and trusts. They are taxed at the top marginal rate (currently an astounding 37%) after the first $12,500 of taxable income.  A single individual needs to be earning over $500K in order to be taxed at that rate.  Let that sink in for a minute.  That's not a type-o.  You can thank Obama for the little tweak to the tax code that compressed the tax brackets for estates and trusts.

That means ~105K goes, 'poof', right to the feds, assuming a ~285K IRA (not counting what your state will swoop in for), if you liquidate and allow the trust to be taxed.  That's before the beneficiaries see even a penny.  Sure, it will be a tax-free distribution by the time they see those pennies, but only after the trust suffers the biggest tax-bite possible.

Don't confuse your situation with the term 'Estate Tax' that the republicans are always thumping the table about.  That scheme only kicks in for multi-millionaires, and is even more brutal, if you can believe it, than what us little folks pay when leaving estates and trusts behind.  That 37% rate is a gift compared to how your trust would be taxed if your mother was really rich.

I was my late uncle's executor and trustee, but I retained an attorney to guide me through the legal land mines.  I asked him how I could liquidate my uncle's IRA, distribute it to the beneficiaries, and have them pay the tax at their own much lower rates, rather than have the trust taxed at the confiscatory 37% rate.

The answer came back that I had to act fast.  I needed to finish probate within the 1st fiscal year of the estate (ending exactly 12 months after the month my uncle passed), get the assets transferred from the estate to the trust, and then distribute the full benefits to all the beneficiaries, before (and this was key) the end of the first fiscal year of the trust.  All of which I was able to do. 

Then I hired a tax accountant to file a K1 form for the estate so that the estate's tax liability would be transferred to the trust, and then had them file a K1 for each of the beneficiaries, which then transferred the trust's taxable income to the beneficiaries, to be taxed at a their own much lower rate.  Two of the beneficiaries were charities, so they paid no tax at all.  But I still had to file K1s for them to move the taxable income out of the trust for their portions.

I don't honestly know if there was some other option if I had taken longer than 12 months to wrap up.  As trustee you'll need to file tax returns for the trust every fiscal year that it exists.  It's not just your ongoing effort you need to consider.  You might have a limited window to figure out how to avoid that brutal tax bracket.

If the IRA is held in a trust, you might not have the option of withdrawing whatever your want whenever you want to, without possibly incurring some pretty severe tax consequences, or the risk of running afoul of your state's probate laws.  According to my information, a successor trustee cannot "split" an IRA held in trust into multiple individual IRAs for the beneficiaries.

I would definitely get some advice from a professional before I made any decision. And I would certainly not delay in getting that professional advice.  A viciously important clock might well be ticking down right now.

Taking a one-year tax hit at your own tax rate seems brutal, on the surface, but compared to the 37% rate the trust would otherwise pay, it seems like a walk in the park by comparison. It might actually be the right way to go.

Having said all that, if you decide to stick to an RMD-only method of distributing to the beneficiaries, that's the most tax-efficient way to go.  But you'll have to sign-up for a multi-year job as trustee for who knows how long.  Bear in mind that H&R block will charge you much more for filing a K1 than for a return.  Multiply that by three (one K1 one for you and one K1 for each of your sisters), plus the cost of filing a return for the trust each year.  That will be an annual additional cost born by the trust, for as long as you keep the trust open, chipping away at the amount remaining for the beneficiaries as time goes by.

But if you also want to think about having it available as an emergency fund (for you or any of the beneficiaries), you are heading out into treacherous waters.  And not just from a taxation perspective.   If I ever pulled out any money from my uncle's trust for any of the beneficiaries, without making equal distributions to the other beneficiaries at the same time, I would be in violation of my state's probate laws, and could have easily been removed as an unfit fiduciary if ever challenged. 

There's some dangerous ground to cross if your mother didn't set up separate accounts for the beneficiaries under their own tax ids.  I would definitely get professional advice.  It might seem expensive, but it will be a lot cheaper than getting the tax game wrong.

As the fiduciary, the IRS can come after you, personally, for any taxes due not paid by the trust.  It's critical to get that game done correctly.

Personally, I would get some face-time with a probate attorney.  My attorney was the one who understood, explained, and guided me through the K1 strategy.  My tax accountant (H&R block, chosen in honor of my uncle's life-long choice of tax accountant) was just one of the tools I used to implement the strategy.  Only very few H&R block reps even knows how to file a K1 for a client.  I had to drive over 100 miles away in order to get a rep who was available in time to meet my fiscal deadlines.


« Last Edit: September 27, 2018, 07:11:39 PM by ILikeDividends »

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #13 on: September 27, 2018, 07:04:47 PM »
The IRAs are not in the trust.

ILikeDividends

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Re: Is it always bad to cash out an inherited IRA?
« Reply #14 on: September 27, 2018, 07:12:36 PM »
The IRAs are not in the trust.
And if they are not in the estate, then you are good as gold.  Ignore my previous post.  And condolences for your loss.
« Last Edit: September 27, 2018, 07:15:39 PM by ILikeDividends »

Indexer

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Re: Is it always bad to cash out an inherited IRA?
« Reply #15 on: September 28, 2018, 06:58:19 AM »
....

Everything in Seattlecyclone's post. +1  I was going to say most of the same things.


Quote
*If I kept it as an inherited IRA, I would have to receive RMDs and pay taxes on the money at that time anyway. I would honestly rather not fiddle around with RMDs. I think this is kind of my main issue, honestly. I realize the inherited IRA could be used as an emergency fund...but I'd rather have it in a money market account.

Easy solution. Move the inherited IRA somewhere with a high yielding mmkt that also allows automated RMDs. Vanguard would be my first pick with their Prime mmkt yielding over 2.1% right now. Most large financial firms can automate the RMD. You pick the day of the year and the tax withholding, and they will do the rest, including recalculating it each year. ;-)

Yes, you will probably pay taxes on it all eventually, but taking a small amount each year is better than taking it all at once. As an example, 5k/yr for 20 years is likely to keep you in your same tax bracket each year. Taking 95k at once will likely bump you into a higher bracket. Taken a step further, if you're eligible to make IRA contributions, you could take out 5500 from the inherited each year and contribute it to your own traditional IRA. The taxable withdrawal and the tax deductible contribution will largely offset each other. This is the same thing SeattleCPA was talking about.

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #16 on: September 28, 2018, 07:29:03 AM »
The IRAs are not in the trust.
And if they are not in the estate, then you are good as gold.  Ignore my previous post.  And condolences for your loss.

Sorry to give you such a short response -- I do appreciate you taking the time to write me such a cautionary post. Definitely good advice!

quelinda

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Re: Is it always bad to cash out an inherited IRA?
« Reply #17 on: September 28, 2018, 07:30:08 AM »
....

Everything in Seattlecyclone's post. +1  I was going to say most of the same things.


Quote
*If I kept it as an inherited IRA, I would have to receive RMDs and pay taxes on the money at that time anyway. I would honestly rather not fiddle around with RMDs. I think this is kind of my main issue, honestly. I realize the inherited IRA could be used as an emergency fund...but I'd rather have it in a money market account.

Easy solution. Move the inherited IRA somewhere with a high yielding mmkt that also allows automated RMDs. Vanguard would be my first pick with their Prime mmkt yielding over 2.1% right now. Most large financial firms can automate the RMD. You pick the day of the year and the tax withholding, and they will do the rest, including recalculating it each year. ;-)

Yes, you will probably pay taxes on it all eventually, but taking a small amount each year is better than taking it all at once. As an example, 5k/yr for 20 years is likely to keep you in your same tax bracket each year. Taking 95k at once will likely bump you into a higher bracket. Taken a step further, if you're eligible to make IRA contributions, you could take out 5500 from the inherited each year and contribute it to your own traditional IRA. The taxable withdrawal and the tax deductible contribution will largely offset each other. This is the same thing SeattleCPA was talking about.

Thank you so much. Writing this all out and reading everyone's responses has really helped make things clear for me. This is exactly what I'm going to do.