Did you recently receive an inheritance that included a retirement account, such as a 401(k) or IRA? You may wonder when you should and are required to take distributions and what investment strategy will be most effective for your financial situation.
The main characteristic of a retirement program inheritance is that most beneficiaries must deplete the account’s funds within 10 years of the original account holder’s passing. The 10-year rule, passed within the SECURE Act in December 2019, does not specify an amount you must distribute, just that you must withdraw all the funds within 10 years. There are a few exceptions to the 10-year timeframe you may qualify for if you’re the legal spouse not more than 10 years younger than the decedent, chronically ill, or disabled. Different rules apply to minor beneficiaries.
For the sake of this blog, we will focus on non-spouse recipients who do not meet any exceptions. When you decide to take your distributions will determine the type of investment strategy that will best fit your financial needs. Let’s discuss what you should consider when selecting your withdrawal strategy.
Choosing a Withdrawal Strategy
When you decide to start taking distributions may be different from someone else’s approach for several reasons. Below, we’ll outline what may help you determine your withdrawal schedule and how it will affect your investment strategy and planning.
Your current financial situation. If you need the additional cash flow now, taking a lump sum may be an effective path to explore with your inheritance. You should, however, consider how a lump sum will affect your taxes if the account is considerable. Immediate withdrawals could also affect your investment risk tolerance if you plan to rely on the distributions as an extra income stream. However, if you do not need additional income, you may consider how the funds can grow tax-free for a few years or the entire 10 years to take advantage of market fluctuations.
Your next life stage. Are you retiring soon? If you’re planning to retire within five years, your inheritance can be another form of retirement income. In this case, you’ll want to discuss with your financial advisor your options and how a little more risk could benefit your long-term savings. However, let’s say you have seven to 10 years or longer until your retirement. Then, you may benefit from a more aggressive investment strategy and possibly two market cycles to potentially add more value.
Your tax impact. Whenever you decide to start taking your distributions, you should consult with a tax professional about possible tax implications. Every type of retirement account has different taxation on distributions, so it’s helpful to evaluate how your taxes could be affected. If the account is significant, a lump sum may push you into a high tax bracket, and you may determine withdrawing a monthly amount may mitigate a higher tax burden. If the amount is smaller, perhaps a longer-term approach will produce higher, tax-free returns within the required timeframe.
While the 10-year rule may limit when and how to use or invest your money, you have several investment and planning options based on the type of retirement program you inherited, your current financial situation, and your future goals. Once you decide on your withdrawal strategy, it will better inform how to invest your funds to meet your needs. We can help you navigate the different scenarios to understand the short- and long-term financial implications of your withdrawal and investment approach. Contact our team to learn how we can guide you through the complex rules associated with your retirement program inheritance so you can plan for today and prepare for the future.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.