How Inherited IRAs Work

You Can Make Your Children Rich, Even if You’re Not

What’s the best asset my children can inherit from me?

Your IRA is considered to be one of the best assets you can leave as an inheritance. IRAs accumulate growth and income tax free. Money in an IRA accumulates value faster than money in any regular savings or investment account because of that tax free feature. If your child/beneficiary doesn’t need the money, they can leave it in the account to grow until they need it.

That’s true of both traditional IRAs and Roth IRAs.

A qualified Roth IRA is even better: Since the principal amount contributed to the Roth was already taxed, distributions are tax free. Not only that, but the income and growth on the money inside the account also come out tax free.

When does a beneficiary have to take out the money from the IRA they inherit?

There are two sets of rules that apply to distributions for inherited IRAs, the General Rule, and the Designated Beneficiary Rule.

The General Rule

The first is called the “General Rule.” The General Rule has two components, depending on when the owner of the IRA dies, the “5-Year Rule,” and the “MRD” Rule.

The 5-Year Rule applies when the owner of an IRA dies before their Required Beginning Date, April 1 of the year following the year in which the IRA owner reaches age 70 1/2. Under the 5-Year Rule an inherited IRA has to be distributed to the beneficiary within 5 years after the original IRA owner’s date of  death.

If the IRA owner dies after their Required Beginning Date (RBD), the Death After RBD Rule applies. Under that rule an inherited IRA has to be distributed over a period of years equal to the remaining life expectancy of the deceased owner at the time of their death. The deceased owner’s life expectancy is determined under IRS tables.

The Rule for Designated Beneficiaries

However, there is an exception to the General Rule that applies to beneficiaries who are individual human beings.  Beneficiaries who are individuals are called “Designated Beneficiaries.” The rule for Designated Beneficiaries is called the “MRD Rule.” “MRD” stands for “minimum required distribution.”

The General Rule only applies to estates, most trusts, charities, etc. — anybody but individuals. The MRD rule applies to Designated Beneficiaries, individual beneficiaries like your children.

Minimum Required Distributions are just like the distributions that you have to start taking each year from your IRA when you reach 70½. Individual beneficiaries of an inherited IRA have to take out minimum amounts each year over their lifetime. Even if the beneficiary wants to let the account grow tax free until they really need it, “stretch it out” so to speak, they still have to take a minimum amount each year.

A beneficiary can always take out more than the annual MRD, but they must take out the MRD each year.

The ability to take out only these minimum amounts, and let the rest of the account grow tax free, is called the “Stretch Out.” The Stretch-Out allows a beneficiary to take advantage of tax free growth and income inside the account as long as possible.

How do you know how long the beneficiary will live?

The minimum required distribution amount for an individual beneficiary is based on their life expectancy. IRS has a table that tells their actuarial life expectancy for this purpose based on their age.

A person’s life expectancy is the number of years you have a greater than 50/50 chance of living. It changes each year based on how old you are.

For example:

• Let’s say that a beneficiary is 20 years old. The IRS table says their life expectancy is 63 years. In other words, according to IRS there is a greater than even chance that a 20 year old beneficiary will live for an additional 63 years – to a ripe old age of 83.
• The next year, the beneficiary’s life expectancy is shorter. You might expect that if a 20-year-old has a life expectancy of 63 years, a 21-year-old would have a life expectancy of 62 years, but that’s not true.
• Actuarially, if you calculate the life expectancy of a 21 year old, it doesn’t come out to 62 years. According to the IRS table, a person who is 21 years old has a life expectancy of 62.1 years.
• In other words, since they reached the age of 21, now they have a better than even chance of living to a ripe old age of 83.1 years, whereas when they were 20, they only had a better than even chance of living to age 83.

How do you calculate Minimum Required Distributions?

To calculate the MRD for a beneficiary this year, you divide the value of the account on December 31 of the prior calendar year by the beneficiary’s life expectancy on that date. That’s the amount the account has to distribute to them this year..

So, under the MRD rule, a person who is 20 years old has to take out 1/63rd of the value of the account. That’s their MRD. If you divide one by 63, you get 1.58%. So, if the IRA has $100,000 in it, the beneficiary has to take out $1,580.

The following year, the beneficiary is 21 years old. According to the IRS table they have a life expectancy of 62.1 years. They have to take out 1/62.1, which calculates to 1.61% of the account value. It’s more than when they were 20, but still pretty small as a percentage.

How does the “Stretch Out” work?

MRDs Are Small.

Although each year the MRD gets bigger, depending on the beneficiary’s age, while the beneficiary is relatively young, the MRDs are a small percentage of the value of the account. Hopefully the total return of the investments inside the account, the income from the investments and the growth in value of the holdings, is much more.

Our 21 year old had to take out $1,580 as an MRD, but suppose in the meantime that the value of the account grows by 8%. Even if they took their $1,580 at the beginning of the year, the value of the $100,000 account will grow by $7,874, so the account value will be $106,294 at the end of the year.

Earnings Pile Up

Because of the MRD Rule, if the beneficiary takes only the minimum, the return on the investments inside the account can accumulate for a lot of years. As long as the annual return is greater than the beneficiary’s MRD, the IRA will continue to grow until the MRD is the same as or greater than the IRA’s return on its investments.

If you assume a return of 8% on the IRA’s investments, and the account value will grow, until the beneficiary’s life expectancy is less than 12.5 years (1 / 12.5 = 8%). According to the IRS table that’s just over age 76.

In the meantime, for all those years between age 20 and age 76, the account value gets bigger.

It Can Be A Lot of Money!

Let’s assume that a 20-year-old inherits an IRA worth $100,000. Also, suppose the account grows at an average rate of 8%, and the beneficiary, takes out the minimum required distributions at the end of each year until age 77. At the end of that time the beneficiary will have taken out distributions totaling $1,629,577.10!

Not only that, even after all those distributions, the account will be worth $1,314,654.10!

That’s the point of the Stretch Out. Until the beneficiary really needs the money, they should stretch out the tax free growth of the account as long as you can.