Investing

Cashing Out an Inherited IRA

This is a guest post from Gary Foreman, who is the editor of The Dollar Stretcher.com website and newsletters. Click here for more information about how compound interest works.

I decided to run this story because I’ve shared Melanie’s frustrations about friends and relatives many times–sometimes people just don’t want to hear the logical answer and insist on their own ways. What would you do?

Dear Dollar Stretcher,

I have a nephew who just inherited an IRA. I have tried to explain to him, as simply as possible the basics – that money in it will grow untaxed, but the money he takes as a distribution will be taxed. He will not give up on this notion that he needs to take it all out now and invest it or he will suffer dire consequences in the future due to the bad economy. He is like a pit bull on this and will not believe me. I cannot find a simple and short explanation to get the basic concept across to him. Exhausted and frustrated and ready to turn it all over to him and let him find out from the consequences he’ll suffer. —┬áMelanie

Melanie,

You’re right to be concerned about your nephew. Many young people come into inheritances or windfalls and aren’t prepared to properlly manage them. As you pointed out, there are two aspects to his decision. First, the facts of the situation. Second, the emotional element.

I doubt that we can cover it in four sentences, but we’ll try to keep things simple. Let’s start with the facts.

The Facts

You can inherit an IRA. That includes Traditional, Roth, Rollover, and SIMPLE IRAs from a parent or someone other than your spouse.

Your nephew has 3 options available to him. 1) he can transfer the inherited assets to an IRA in his name and begin taking minimum required distributions. 2) Take a cash distribution and pay income taxes on that money. 3) Refuse to accept the inheritance (called ‘disclaiming’ it). You’re recommending that your nephew choose option 1. Sounds like he wants to select option 2.

Money kept within the IRA will not be taxed until it is withdrawn. So any money left within the IRA will grow without taxation. Money that is taken out will be taxed as ordinary income. Any money that distribution earns in the future outside the IRA will also be taxed as income.

Compound interest multiplies your savings. Every dollar in the IRA will earn interest, dividends or hopefully appreciation as long as it is in the account. That means that $1 today will be worth $1 plus interest a year from now. That doesn’t seem like much until you realize that most long term investments will double about every 10 years. And, if your nephew is 20, it would double and redouble 5 times by age 70. So $1 would become $32.

Savings compound faster if taxes are held until the end. If your nephew takes the money out of the IRA and doesn’t spend it, he’ll need to pay taxes on any earnings each year. That will slow it’s rate of growth significantly. Speaking in rough terms, instead of doubling every 10 years, with taxes it would only double every 15 years. So his $1 today would only become $8 by age 70.

Investment choices are similar inside or outside of an IRA. If you nephew wants certain types of investments because of the economy, he should be able to include them in a self-directed IRA. An investment inside of an IRA is no more or less safe than an outside investment.

If he chooses to take all of the money out now he cannot change his mind later. If he leaves it in the IRA he can always take a larger distribution any year or take the entire balance out at any time.

Sacrificing now could pay dividends every year for the rest of his life. If he chooses to take the money out now and spend the inheritance, it will be gone forever. Leaving the money in the IRA will means a steady stream of checks.

Taking the money out of the IRA increases the odds that the money will be spent. It’s possible that your nephew will have the discipline to take the money in a lump sum, invest it and save it for the future. But he’ll need to be strong to avoid the siren song of spending it if it’s readily available. Many people, especially younger people will quickly spend windfalls.

The Emotional Element

OK, we’ve looked at the financial facts. Now, let’s deal with the emotional aspects.

Younger people have a limited horizon. They simply can’t think very far in the future. It’s difficult for someone who has only lived 20 years to imagine their lives 30 years in the future. A financial benefit that far our seems almost imaginary to them.

Your nephew puts a greater emphasis on ‘today’ than on sometime in the future. That seems natural to someone his age (and perhaps the elderly, too). So it feels right to use the inheritance now instead of sometime in the hazy, distant future.

Your nephew wants to make his own decision. Part of becoming an adult is getting to make your own decisions. Even if they don’t turn out well. It’s important to prove to others (and yourself) that you’re allowed to make important decisions. And, part of that sometimes means not listening to elders who are trying to tell you what to do.

Ultimately that really is the bottom line. If he’s of legal age, it is his decision to make. You can present the facts and arguments for using the inheritance wisely. But, you cannot force him to make the choice that you think is best for him. No matter how sure you are of your choice and how much you care for his well-being. At some point you may need to decide to just love him. Even if his choices don’t meet your approval.

Wojo’s note: Frustrating, isn’t it? But Gary makes an important point–no matter how much we try to mean well for others, it’s still their decision to make, and sooner or later we have to come to peace with that.

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