Leaving a big IRA to your kids?—Why this strategy is coming to an end
Over the years I’ve met with many good savers. Most have been diligent about putting money away in their 401(k)s and SEP-IRAs for retirement. A few have been super aggressive, maxing out their contributions to all available traditional, pre-tax plans for decades resulting in large balances. For upper middle income and high income families, maxing out contributions can help lower taxable income during the working years when income can be pretty high. This usually results in a healthy retirement nest egg. What could be wrong with that?
The old rules for inheriting IRAs from your parents
Before the last major tax reform act, if a married couple died, they could leave their IRAs and 401(k)s to their adult children who could begin taking small payouts, known as Required Minimum Distributions (RMDs). These distributions were based on the adult child’s life expectancy. For a 55-year-old inheriting a $1 million IRA from a parent, that meant taking an annual RMD of $31,646.1 That distribution represents only 3.2% of the account value. As the 55-year-old gets older, the RMD typically increases as the account grows and the life expectancy factor changes. After all, the IRS wants the account to be emptied by the time the 55-year-old dies. However, the small RMD used to allow nearly all of the account to grow tax-deferred over the beneficiary’s lifetime. This so called “stretch IRA” allowed many adult children to benefit from large IRAs and 401(k)s accumulated by their parents. No more.
The big IRA tax surprise when one’s parents die
Today a non-spouse beneficiary, such as an adult child, cannot stretch out the RMDs over their lifetime. They can either take it as an immediate lump sum or spread it over a 9-year period—not 30 more years. This is having a big impact for some adult beneficiaries. Using the 55-year-old again, that’s either taking an immediate distribution of $1 million, or yearly distributions of $111,111 over a maximum of 9 years.2 Either way, if the adult child is still working, that is either $1 million or $111,111 per year additional taxable income. Even if the beneficiary spread the required payouts over 9 years, a family with taxable income of $380,000, this income would push the beneficiary from the 24% federal tax bracket into the 35% tax bracket for 9 years.
Strategies for big IRAs
There are a number of different approaches for those with big pre-tax IRAs and 401(k)s. However, each approach is dictated by one’s particular circumstances. Ages of owner and adult children, personal health, tax bracket, other financial resources, and income needs of both the owner and potential beneficiaries need to be considered.
With taxes scheduled to revert to higher rates beginning in 2026, Roth conversions may be worth considering to reduce IRA balances and potentially future RMDs. But those need to be balanced with the amount of additional tax that will be due now on each conversion as well as the individual’s current tax bracket.
The bottom line is that the strategy of saving as much as you can may have created the unintended consequence of a big tax bill for non-spouse beneficiaries, especially if they are still working.
If you have a big IRA or 401(k), give me a call. We can work together to figure out the best way for you to enjoy retirement without leaving a big tax burden for your adult children. You can schedule a quick call with me by clicking HERE.
Lyman H. Jackson
Lyman@PlanWithFPS.com
617-653-3303
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1 RMD for an unmarried non-spouse beneficiary; IRS Table I. (Single Life Expectancy). Source: https://www.irs.gov/publications/p590b#en_US_2022_publink100089977
2 In 2024, additional taxes may apply when earned income exceeds $200,000 (single filer) or $250,000 (married filing joint). For beneficiaries on Medicare, additional income could cause the beneficiary’s Medicare premiums to increase during distribution years.
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.