Inheritance tax bomb: Leaving a large IRA to adult children
When you are filling out an application for a IRA or signing up for your employer’s 401(k), one of the most important sections is completing the beneficiary section. If you are married, it is common to list your spouse as your primary beneficiary. And, if you have children, most of us list our kids as contingent beneficiaries. However, if you are approaching retirement and your children are working young adults, leaving your pre-tax retirement accounts to them might create an inheritance tax bomb.
Saving as much as you can during your working years into a pre-tax retirement plan worked well for a long time. During your earning years it was one of the few options to reduce taxable income and also build up your retirement nest egg at the same time. But the benefits of this approach are not as clear-cut as they used to be.
Inheriting a pre-tax IRA
Consider the fictitious couple of John and Mary Smith. They have two adult children, Suzanne age 38 and Pete, age 36. John dies at age 70 leaving Mary, his primary beneficiary of his pre-tax IRA. There is no tax due and the account transitions to Mary to support her retirement. However, Mary falls ill and dies a few years later at age 72. Suzanne and Pete are the primary beneficiaries on her IRA.
John and Mary were good savers over many years. They both maxed out their 401(k)s at work which they rolled over to an IRA now worth about $3 million.
Suzanne and Pete are both married and their family incomes are $375,000 each putting them into the 24% federal income tax bracket.
In the old days, Suzanne and Pete could inherit their respective shares of Mary’s IRA and then start taking Required Minimum Distributions based on their life expectancies. This allowed them to spread out the taxable distributions over their respective lifetimes which would be about another 45-50 years. That tends to leave most of the IRA intact to grow for a long time. No more.
Nine years
Suzanne and Pete must now start taking RMDs, but under current law have only nine years to completely empty their inherited IRAs. Even if they spread out their distributions evenly over nine years, they would still need to take out about $166,667 each year.1 That is taxable income that will be added to their existing income of $375,000 for total taxable income of $541,666. This higher income pushes them into the 35% federal tax bracket for nine years. For Suzanne and Pete, they are now faced with a higher tax rate on this additional income quite possibly at a time when they really don’t want to pay more in taxes and may not need the distributions.
The inherited IRA tax trap
This situation calls into question the longstanding practice of “just max out your 401(k)” with pre-tax money. While some workers are contributing after-tax money to Roth IRAs or Roth 401(k)s most people are not, especially those in higher income brackets like Suzanne and Pete who are looking for ways to reduce their taxable income.
As pre-tax 401(K)s and IRAs grow, the risk of large RMDs over a short period increases. This has the effect of concentrating taxable income.
How to manage or avoid the trap
There are ways to manage these situations including directing some or all of your 401(k) salary deferrals to after-tax Roth contributions or converting pre-tax balances to after-tax ones.
The ages and family incomes of your adult children matter, too. If none of them are high income earners, the tax jump may be less significant. Or, if the RMDs are small, this may be less important.
After distributions begin, beneficiaries may also be able to arrange their income or tax deductions in a way that reduces their taxable income. However, this is not always feasible depending on each individual situation.
If you are looking at a big, pre-tax IRA, give me a call. I’m here to help. It is easier to begin planning for distributions now rather than after RMDs have begun. You can schedule a quick call with me by clicking HERE.
Lyman H. Jackson
Lyman@PlanWithFPS.com
617-653-3303
1 This hypothetical illustration does not include investment growth which invariably would cause the distributions to be even larger.
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· Should I count on an inheritance? https://planwithfps.com/blog/should-i-count-on-an-inheritance
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