Inherited IRA Withdrawal Questions

7 Replies

Hey Guys,

I recently inherited a traditional IRA (Non-spouse) and would appreciate additional feedback from those who are familiar with what options I would have. I am looking to pull out about $100k right now in order to purchase some investment properties.

The big question I have is, will I be able to transfer this into my LLC which then can be used as an investment to avoid/defer tax?

From what I understand, self-directed IRA's are able to avoid tax when investing directly into something that is considered an investment.. real estate. Only problem is I cannot do that since I'm not the spouse.

I have spoke with my accountant and he said that we can accelerate depreciation up front in order to avoid the large tax hit initially. Downside is when it comes time to sell, I would be hit with depreciation recapture tax. From what I've read, it would be a maximum of 25%, which still would be better than income tax. 

@Joe Wood

The distribution from the IRA to yourself is a taxable event. There is not anything you can do to change that. Taking a large chunk such as $100K out of an IRA all at once will put all of your income for the year in a higher tax bracket.

From there anything you do with the after-tax money is fine.  Of course, if you then generate additional taxable income, that is something you can work to mitigate with your CPA.

You could choose to form a self-directed IRA and invest the money directly into real estate. Any IRA, including an inherited account, can be setup to be self-directed. The IRA funds would not be able to be combined with other personal funds as in your note above. Rather than deplete the tax-sheltered IRA, you could continue to grow it and only distribute to yourself the minimum amount required, or perhaps a bit more here and there as suitable.

With a non-spouse inherited IRA you have (up to) 4 choices:

-Cash it all out now

-Cash it all out over 5 years

-Take required minimum distributions based on your life

-Take required minimum distributions based on the life expectancy of the oldest beneficiary of the inherited IRA

Each of those options has different tax implications. None of those options includes "taking $100,000 now and letting the rest sit in the inherited IRA until I make another plan". (Not saying that was where you were going, but just wanted to make sure that was understood.)

Make sure the custodian of the IRA (Fidelity, Schwab, Vanguard, whoever...) knows what you want to do. Once they distribute it you can't put that genie back in the bottle. (I've had numerous clients who wished they could!)

Hi Joe,

Let me correct what may be some misconceptions. 

First, in general, holding a real estate investment in an LLC won't necessarily, by itself, help you avoid or defer taxes. Unless you choose to have the LLC taxed as a corporation, the income and deductions (including depreciation) flow through to the LLC's owner(s).

Second, you can invest the inherited IRA as a self-directed IRA, even though you are not the decedent's spouse. (Also, the self-directed inherited IRA could hold the real estate it purchases in an LLC.)

True, you can't get the special benefits available to a surviving spouse who inherits their spouse's IRA -- e.g., treating the IRA as their own, doing a "spousal rollover" to a new account, and not being required to take minimum distributions until their required beginning date. Also, you will pay ordinary income tax on whatever gets distributed to you from the inherited IRA, so the $100,000 you are talking about "pulling out" from the inherited IRA (assuming you mean as a distribution) will be taxable ordinary income this year.

However, you do have the option to invest the inherited IRA in real estate with a self-directed (inherited) IRA. To do that, you would transfer all or part of your current IRA account to a new custodian that allows you to self-direct investments. First, you open a new "inherited" IRA account at the new self-directed custodian, and then do a "custodian to custodian" transfer of some or all of the liquid funds from your existing inherited IRA to the new, self directed, inherited IRA. This is not a "60-day rollover." Then you instruct the current custodian to transfer funds directly to your new account at the new custodian. (Both custodians will have forms for you to fill out and submit.) Then you can do your real estate investing directly from the new self-directed inherited IRA.

One thing to watch out for with self directed inherited IRAs, is that you will be required to take minimum distributions from both inherited IRAs described above now, based on your life expectancy. (IRS provides tables to calculate the amount(s) based on your life expectancy each year.) Depending on your age, that may be a small amount at the beginning, but it gets to be a bigger percentage of each account as you get older and your life expectancy gets shorter (according to the IRS table). 

Minimum distributions from any IRA are hard to do with non-liquid assets like a real estate investment held in a self-directed IRA. In order to calculate the required amount, you have to value the account itself, which includes valuing its specific investments, e.g., the real estate held by the account. That means you have to have a reasonable method of valuing the real estate holdings at market value as of 12/31 each year so that you take out the required minimum distribution amount. The self-directed custodian will ask you to value the real estate held each year, and will report that value to IRS. The minimum distributions you take and report on your income tax returns have to be based on the values reported by the custodians to IRS, so it's important to be accurate. You need to be comfortable that the value of the real estate you report to the custodian will pass an IRS audit. IRS is beginning to look more closely at valuation of self-directed retirement accounts, and they don't like it if you "under distribute."

For a bunch of reasons you won't want to take minimum distributions "in kind" as a percentage of the real estate held by the self-directed IRA. So, you should hold back enough liquid assets in the inherited IRA(s) to cover your estimated required minimum distributions from them over the expected life of the real estate investment. If you retain the original inherited IRA in liquid investments at the current custodian, but transfer only the amount you expect you will need for the real estate investment to the new self-directed inherited IRA account, you can take the required minimum distributions for both accounts from the one holding the liquid investments.

Anyway, the whole point of all this is to enable you to invest your inherited IRA in real estate and defer taxes on the income until you have to take out taxable distributions. Otherwise, you pay income tax at your current marginal rate on the $100,000 distribution you mentioned, plus income tax on subsequent profits from the investment (which you would own personally).

Consequently, I'd compare your projected returns net of all taxes on the real estate investment (1) based on taking a current distribution of $100,000 and holding the real estate personally, and (2) based on holding the real estate investment in the inherited self-directed IRA. Be sure to factor in the effect of Unrelated Business Taxable Income (UBTI) if you borrow money (non-recourse loans only) to purchase the property by the self-directed IRA. Since you can take depreciation against other income on property you hold personally, but only against UBTI in your self-directed inherited IRA, #(1) may be your best option. Be sure to do the numbers.

I hope this helps clarify your options. Happy investing!

Thank you all very much for your responses. Since my father was not over the age of 70, we are not required to have minimum withdrawals. My financial planner who is overseeing the account has said that I can take out any amount during any period of time (does not matter if it's one lump sum, five years or life expectancy). 

@Frank L. Bridges

Very thorough response, thank you!

I was not aware that you are eligible to invest an inherited IRA into a self-directed. If I were to do this, would my cash flow from rentals have to be reinvested into the account? or would I be able to keep this income?

Also, I would be required to take minimum distribution amounts in the new, self-directed IRA? Even though I am not required to take distributions in the current, inherited IRA?

Joe, inherited IRA certainly can be rolled over into self-directed IRA. Yes, if IRA buys investment property all income would belong to an IRA and must be deposited into IRA. You can take distributions from the IRA. 

You are required to take distributions from an Inherited IRA, self-directed or not.