The Cost of Deferring

In 2019, the passing of the Setting Every Community Up for Retirement Enhancement Act (SECURE) reduced or removed many tax benefits from an inherited IRA for non-spouse beneficiaries. Prior to SECURE, the beneficiary of an inherited an IRA or other qualified account was allowed to stretch distributions over their life expectancy and minimize the amount of taxable income each year. Since SECURE passed, most non-spouse inheritors are required to fully distribute the account within 10 years after the death of the original account owner. This can significantly increase their amount of taxable income and create considerable tax implications that may have people thinking about waiting as long as possible to distribute the funds to delay that tax pain. That delay may cause even bigger headaches as the balance grows during those years and the higher balance being disbursed all at once can push the inheritor into higher marginal tax brackets.

To understand the effects of delaying distribution, let’s look at the following example:

Taylor and Alyx are a married couple who are both age 50.

• Adjusted Gross Income (AGI): $150,000
• Standard Deduction: $27,700
• Taxable Income: $122,300
• Federal Tax Bracket: 22%
• Capital Gains Tax Bracket: 10%
• Inherited IRA Balance: $500,000

Based on their taxable income, they could earn an additional $68,450 before they would be above the 22% marginal tax bracket. The below chart illustrates the differences between distributing just enough money to remain in their current bracket each year and reinvesting those dollars versus taking a lump sum distribution in the 10^th year after the original owner’s death.

*Assumes a 6% growth rate on the IRA and an after-tax return of 5.10% for the reinvested dollars

By making distributions over the course of the 10-year period up to the limit of their marginal bracket, Taylor and Alyx were able to reduce their potential tax exposure by $132,254 and increase their IRA account balance by $61,162.

Keeping the details of the above example in mind, let’s consider what would happen if Taylor and Alyx both have 401(k) plans to which they are each contributing $12,000 per year. This would mean they have an additional $18,000 each that they could contribute to their 401(k)s each year. If they were to allocate a combined $36,000 to their 401(k) accounts, they could use the proceeds from their inherited IRA distribution to offset the reduced cash flow caused by increasing their 401(k) contributions. Assuming their 401(k) contributions are pre-tax, their income would be reduced by the $36,000 with the additional contributions offsetting the amount of the inherited IRA distribution. In this case, out of the $68,450 distribution, their increase in taxable income would be just $32,450. The chart below shows how this scenario would play out:

By making distributions over the course of the 10-year period and maxing out their 401(k)s, Taylor and Alyx were able to reduce their potential tax exposure by $205,947 and increase their balances by $87,527. Moving additional dollars into their own 401(k) while depleting their inherited IRA also allowed them to shrink an account that has mandatory distributions over 10 years and reallocate those dollars into their 401(k) where they can stretch distributions over their own life expectancy, plus 10 years beyond that for their own heirs.

There are multiple considerations for people who have inherited an IRA, and it is worth sitting down with your advisor and tax planner to develop a plan that makes sense for you and your family.