As we discussed last week, the purpose of the recently passed Secure Act was to make it easier for workers to save for retirement. Pretty much everybody acknowledges there’s a retirement savings shortfall in our country, so every little bit helps. The downside, however, is that laws making tax deferred savings easier must be paid for, and this was largely accomplished on the backs on those set to inherit retirement accounts.
Remember that IRAs, 401(k)s, and other types of retirement accounts weren’t originally intended to pass on wealth to heirs. They were meant to fund retirement and perhaps help with a surviving spouse. As we’ve seen over time, too-good-to-be-true-for-long tax loopholes eventually get closed. This is what happened several years ago with the Social Security “file and suspend” loophole that created a cottage industry of books, seminars, and so forth that for years helped folks “maximize” their benefits.
I’m a firm believer in understanding the rules of the game and playing the game hard, but I also try to acknowledge when something has to give. The victim this time around was the concept of “stretching” inherited retirement accounts.
Beneficiaries used to have two main options for retirement accounts they inherited. If the deceased owner was taking required minimum distributions (RMDs), heirs could start taking them on their own the year following the account owner’s death. Or, they could choose to clean out the account within five years. With some good investment management and proper planning, it was possible to try to stretch some of the money for decades, or even into the next generation. This also allowed more control over the timing and amount of taxes. No longer. Those inheriting retirement accounts will now have just one choice, to draw down the balance within ten years.
While these changes impact a broad array of beneficiary scenarios, here’s one that’s likely to start coming up:
Too much income too soon…
Jane’s mother passed away and left her a 401(k) worth $300,000 and a Roth IRA worth $150,000. While she’s mourning the loss of her mother, Jane is 60 and wondering how the extra money and extra taxes will impact her retirement plans.
Jane had saved enough to retire around age 65. She had also planned on the years from 65 when Medicare would kick in and 67 or 70 when she’d start taking Social Security, to be some of the lowest taxable income years of her life. Because Jane would like some tax-free income later on but hasn’t yet made any contributions to a Roth IRA, her humble financial planner suggested filling up those income “gap years” with Roth conversions. This would reduce Jane’s RMDs on her own retirement accounts in the future and would allow Jane some tax-free income later in retirement.
But how should Jane plan to draw down the inherited accounts?
Jane’s first alternative is to draw the money more or less evenly over ten years. Doing so would add about $30,000 of taxable income to her $150,000 salary at work for the next five years. This alone will bump her from the 24% federal tax bracket to 32% as a single filer.
Then, if she stops working as planned at age 65, she’ll still have to pay tax on five more years’ worth of $30,000 inherited distributions. Her planned Roth conversions (which are taxable) now make less sense because a higher tax bill reduces the effectiveness of the concept. She’d rather have the $30,000 of distribution go into her Roth, but that’s not possible with inherited IRAs, just with her own.
Another issue for Jane when she turns 65 and starts Medicare is that her premiums are based on income. As a single filer, taxable income over about $85,000 means a premium surcharge every month that potentially lasts several years. If she keeps working, does a Roth conversion, or brings in other income, the inherited distributions could kick her into this surcharge range.
Her other alternative would be to take the money in chunks during the ten-year period. But this would mean paying tax in chunks as well. For example, if Jane let the account grow for the next five years while she was still working, she could have a future balance of, say, $350,000 and only five years to draw it down. She’d have $70,000 a year to pay taxes on, higher Medicare premiums, and probably no Roth conversions on her own.
And then there’s the inherited Roth. Jane will also have ten years to deplete this balance, but at least the distributions won’t be taxable. This will be bittersweet because Jane will have tax free income for ten years, just not when she needs it.
I suppose a third option is that the inherited retirement money could let Jane retire earlier, either in full or in part. But if she’s not yet ready to retire she has to manage the problem of having too much income too soon.
So, the Secure Act will likely cause some planning conundrums for folks like Jane who find themselves inheriting retirement accounts at the wrong time in their life. This is a good problem to have, of course, but one that will require proper planning to resolve efficiently.
Have questions? Ask me. I can help.
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