Individual Retirement Accounts (IRAs) are one of the most popular ways to save for retirement, and most workers are familiar with the general rules surrounding their use. However, when an IRA is passed down through inheritance, the rules change. While inheriting an IRA can be a boon, it’s crucial to understand the rules governing it to avoid unnecessary taxes or penalties. 

Understanding IRAs: the basics

Before diving into the intricacies of inherited IRAs, it’s helpful to understand the foundational principles governing them. 

Traditional vs. Roth IRAs

With a traditional IRA, contributions are tax-deductible, which means you don’t pay taxes on the money you put in, only on what you take out. When you make withdrawals in retirement, they are taxed as ordinary income. 

With a Roth IRA, contributions are made with after-tax dollars, so withdrawals are generally tax-free in retirement. 

Required minimum distributions (RMDs)

Required minimum distributions (RMDs) refer to the minimum amount that account holders are obligated to withdraw from their IRA annually once they reach a certain age. For traditional IRAs, this obligation begins at age 72 (73 if you reach age 72 after Dec. 31, 2022). 

Roth IRAs do not impose RMDs during the lifespan of the account holder. 

Inherited IRAs: distinct rules for different beneficiaries

In the context of inheritance, the relationship between the original owner and the beneficiary dictates the operational rules of the IRA. It also matters whether the original owner died before or after they started taking RMDs. 

The simplest scenario is when a surviving spouse inherits an IRA after their partner’s passing. In such a case, the surviving spouse has the unique option to treat the IRA as their own, which means they can make contributions or delay distributions until they would normally be required to take RMDs. This is the only scenario where a beneficiary can treat the inherited IRA the same as a personal IRA.

General rules for non-spousal beneficiaries

When you inherit an IRA, and you’re not the spouse of the original owner, you need to keep the following general rules in mind: 

• No contributions. You cannot contribute to an inherited IRA the way you would a personal IRA. You can take money out, but you can’t put anything in. 

• No commingling. You cannot merge funds from your personal IRA with an inherited one and vice versa. 

• Ten-year rule. The ten-year rule requires most non-spousal beneficiaries to liquidate the entire balance of an inherited IRA within a span of ten years. 

• Continuation of RMDs. If the original owner had already started taking RMDs, the beneficiary must continue taking the RMDs after the owner’s death, regardless of the beneficiary’s age. In addition to the RMDs, the beneficiary is still obligated to liquidate the account within ten years. 

• Absence of RMDs. If the original owner had not started taking RMDs, the beneficiary is not required to withdraw a set amount each year, but they are still bound by the ten-year rule. 

Eligible designated beneficiaries

Although relatively rare, there is another distribution option for a select group of individuals the IRS refers to as “eligible designated beneficiaries” or EDBs. 

EDBs can include heirs who are:

• Less than ten years younger than the deceased, 

• Chronically ill, 

• Disabled, or

• Minor children of the original account owner. 

These beneficiaries have the option to stretch RMDs over their life expectancy or the original owner’s remaining life expectancy, whichever is longer. They can also adhere to the ten-year rule if the original owner had not started taking RMDs yet, although this is an option and not a requirement. 

Tax implications of inherited IRAs

Inherited traditional IRAs come with strings attached in the form of taxes. However, inherited Roth IRAs come with a bit of a silver lining. Since the original contributions were made with post-tax dollars, distributions are typically tax-free. But there’s a catch: the account must have been open for at least five years. If not, the earnings will be subject to taxes, but the contributions made by the original owner remain tax-free. 

Most beneficiaries are subject to a 10-year payout period for IRAs inherited in 2020 or later. If you fail to withdraw the full balance by the end of this period, you could face a penalty of 50% of the amount that should have been distributed. 

Also, missing a required minimum distribution or taking less than the required amount results in a 25% penalty on the shortfall. 

Strategic moves for inherited IRAs

Inherited IRAs might be complex, but they also come with many possibilities. Knowing the nuances can help you get the most out of your inheritance while sidestepping potential pitfalls. 

You have the power of movement. 

Just because you’ve inherited an IRA held by a particular custodian doesn’t mean you’re tied to them for life. If the investment options don’t align with your goals, or if you’re unsatisfied with the service, it’s possible to move your inheritance to a different custodian. But this needs to be done via direct transfer. This means funds must move directly between the institutions without you ever taking possession. Any indirect movement could be considered a taxable distribution. 

It’s also imperative that the receiving account is explicitly labeled as an inherited IRA to avoid tax complications. 

Consider your tax bracket. 

If you’re on the cusp of a higher tax bracket in a given year, it might be wise to delay a distribution if you’re subject to the 10-year rule. Or, you could take a smaller distribution to avoid pushing yourself into that higher bracket. 

Leverage charitable distributions. 

If you’re 70 ½  or older, you may want to consider Qualified Charitable Distributions. You can transfer up to $100,000 annually from the IRA to a qualified charity, which will count toward your RMDs. The donated amount is excluded from your taxable income. 

Consult a professional advisor

There are many variables when it comes to inherited IRAs, and each person’s situation is unique. While this article provides an overview of inherited IRAs, it is not a substitute for speaking with one of our expert advisors about your specific situation. Contact our office to discuss minimizing taxes and adhering to all IRS rules for your IRA.

Effective working capital management can make all the difference between success and failure in the business world. But how can businesses manage their working capital effectively? 

In this article, we’ll explore the basics of working capital management. We’ll also dive into specific techniques that you can use to better manage capital and optimize liquidity.

What is the importance of working capital? 

Working capital is a crucial financial metric that measures your company’s ability to meet its short-term financial obligations. It’s the difference between your current assets, such as cash, accounts receivable, and inventory, and your current liabilities, such as accounts payable, short-term loans, and other obligations due within a year. 

Working capital is critical for the survival and growth of a business regardless of its size or industry. A company with a strong working capital management plan is better positioned to withstand unexpected financial challenges, such as economic changes, cash flow disruptions, and unexpected expenses. Effective working capital management can also help a company improve its profitability by reducing the need for costly short-term financing options. 

Working capital ratios to track

There are several important working capital ratios that you can use to track your financial health and manage your cash flow effectively. These ratios provide insights into your liquidity, efficiency, and overall financial performance and can help identify potential areas for improvement. 

Current ratio

The current ratio measures your ability to pay your short-term debts using current assets. It is calculated by dividing current assets by current liabilities. A good current ratio varies depending on the industry and the company’s circumstances. However, as a general rule, a current ratio of 2:1 or higher is considered good.

A low current ratio indicates that your business may not have sufficient liquidity to cover your short-term debts and operational expenses. It may also signal to investors that your company is not well-managed or is experiencing financial stress. 

On the other hand, an excessively high current ratio suggests that your company has excess funds tied up in current assets, which could be better utilized elsewhere. It can also mean your company is not efficiently managing its inventory. 

Quick Ratio (aka Acid-Test Ratio)

The quick ratio is similar to the current ratio, but it measures a company’s ability to pay off its current liabilities with its most liquid assets, such as cash, marketable securities, and accounts receivable. It is calculated by dividing quick assets by current liabilities. A higher quick ratio indicates that a company has sufficient cash and other liquid assets to cover its short-term obligations.

Inventory Turnover Ratio

The inventory turnover ratio shows how effectively your business manages its inventory levels. It is calculated by dividing the cost of goods sold by the average balance sheet inventory. This ratio indicates how quickly you’re using and replacing your inventory. 

A low ratio may suggest that your company is holding onto excessive inventory levels, which can lead to increased costs and obsolescence risk. Conversely, a high inventory ratio could indicate inadequate inventory levels, potentially leading to missed sales opportunities. 

Days Sales Outstanding Ratio

The days sales outstanding ratio measures the efficiency of your company’s accounts receivable management. It reveals the average time you take to collect payment after a sale transaction. The lower the ratio, the better your company is performing. 

The ratio is calculated by dividing accounts receivable by average daily sales. The result shows how quickly your company turns its outstanding receivables into cash. A low ratio suggests that you are collecting payments more efficiently, which can positively impact your cash flow, profitability, and overall financial health. 

Days Payable Outstanding Ratio

The days payable outstanding ratio measures how quickly a company pays its suppliers. It is calculated by dividing accounts payable by average daily purchases. A high DPO indicates that a company manages its cash flow well and has a strong bargaining position with its suppliers.

Managing Working Capital

Measuring working capital is one thing, while managing working capital is another. The following are strategies to help improve your working capital metrics.  

Analyze current financial statements and create projections

Current financial statements are required to calculate your working capital ratios accurately. While your financial statements and working capital metrics provide current and historical insight, projections will help you analyze and navigate the future. Create and maintain income statement, cash flow, and balance sheet projections. All too often, business owners focus on income projections when changes in the balance sheet can greatly affect cash flow. For example, an investment in machinery or equipment or non-renewal of a loan can drain cash normally available for operations.  

Perform a scenario analysis

Stress test your projections across multiple scenarios and consider how your company might navigate through them, especially in today’s volatile, uncertain, complex, and ambiguous (VUCA) business environment. This is referred to as scenario analysis, and it can help you develop contingency plans to manage your working capital better and avoid cash flow shortfalls. 

To perform an analysis, consider various scenarios, both positive and negative. For example, a positive scenario could be launching a successful new product or service that increases sales and revenue. In contrast, a negative scenario could be a sudden economic downturn or change in consumer behavior that reduces demand for your products or services. 

Manage inventory

Too much inventory can tie up working capital, while too little inventory can lead to stockouts and lost sales. Implement inventory management systems to optimize inventory levels, reduce carrying costs, and improve cash flow.

Improve collections

Monitor your accounts receivable aging report and follow up with customers who have overdue payments. Implement efficient invoicing and payment processes, such as offering discounts for early payment or implementing an automated billing system. Finally, review your process for extending credit to customers; a high DOS (Days Sales Outstanding) ratio may be due to your customer’s ability to pay their bills.

Manage accounts payable

Negotiate favorable payment terms with suppliers to maximize payment flexibility and reduce the risk of late payment penalties. For instance, you might negotiate discounts or longer payment periods, potentially shifting 30-day payment terms to 60 or 90-day terms. Take advantage of early payment discounts and consider using electronic payment systems to streamline payment processing.

Right-size your expenses

One way to improve working capital is to increase profitability. Reassess all expenses to identify those that can be reduced or cut altogether.   

Review available credit

Banks are more willing to extend credit when you don’t need it. Therefore, plan ahead and secure a line of credit or other available credit before needing it.  

Seek professional advice

Effectively managing working capital can be intricate and demanding. This article is meant to provide an overview of working capital management and is not a substitute for speaking with one of our expert advisors. Consider seeking advice from one of our advisors, who can help you identify opportunities for working capital improvement and provide guidance on best practices. Please contact our office to discuss your unique situation.