Planning for an Inherited IRA

Written by Chris DeVito

401(k)’s and IRAs have been a mainstream tool for decades that allow people to save for retirement while deferring taxation on gains. What you “get” is the deduction on your income & the untaxed compound growth until you eventually withdraw the money. The “give” is that you relinquish access to these funds until age 59 ½ (unless you pay a penalty), pay taxes on all of the funds upon withdrawal (including gains), and allow the IRS to dictate how much you withdraw once you’ve reach age 73 (via Required Minimum Distributions or RMDs for short).

Seems straightforward, right?

One issue that I’ve seen in my career is what happens when you don’t want or need the RMD? You cannot avoid it because the IRS forces you to start taking distributions. If you’re still earning significant income in other areas, the RMD may bump you into a higher tax bracket (see tax bracket table later in the blog).

Now, not everyone has the issue of earning a large income during their RMD years. But consider this: what if you are in your peak earning years and have a parent with a significant IRA (that they don’t really need) that you stand to inherit? New rules state that an inherited IRA (unless inherited by a spouse) must be fully withdrawn by the end of the 10th. This is a much different timeframe than the original holder’s lifetime distribution schedule.

Case Study

Mom (Widowed) – Is 85 Years old has a Traditional IRA in the amount of $1,500,000 but has enough assets outside of her IRA to live off. She does not need to draw income from her IRA so only takes the RMD each year. She only needs about $100,000 each year to pay for her living expenses and gifts for her family and church.

Son (Only Child) – Is in his peak earning years making over $750,000 per year. He will eventually inherit his mother’s assets and if there are any funds left in the IRA, will be forced to withdraw them over the span of 10 years.

Now, that last part is where the potential issue can pop up. First, let’s examine the Tax Brackets Below.

At current income needs, mom would fall into the 22% bracket and son would fall into the 37% bracket. Which rate would you rather pay taxes on?

While the IRS does not allow retirees to convert RMDs into Roth IRAs, they do however allow you to convert funds above the RMD amount to Roth even after reaching age 73.

Scenario 1-

Mom has an RMD of $100,000 (putting that distribution in the 22% bracket). She elects that year to convert an additional $90,000 to Roth (which largely will be taxed in the 24% bracket). In this scenario she will pay roughly $21,500 in taxes on that amount, but the funds will then grow tax-free in a Roth IRA until she passes. Including the taxes paid on the original RMD, mom pays roughly $43,500 in tax this year on the IRA withdrawals.

Scenario 2–

Mom does not convert any funds to Roth. Upon her passing her son will start to withdraw the funds over the course of 10 years. We’ll use the same #’s for this calculation although note that RMDs may differ once an IRA is inherited. Son is now forced to take the RMD of $100,000 but also wants to redo their kitchen so withdraws an additional $90,000. These withdrawals will be lopped right on top of his income for the year (which is $750,000), falling into the 37% bracket incurring taxes of $70,300. This amount is over 60% more in taxes than mom would have paid!!!

The Takeaway

Obviously, nobody wants to pay more in taxes than is required. Pulling out more than your RMDs, especially when it bumps up your bracket slightly, can seem like a silly idea. But, given your specific situation and who your beneficiary is (and where they may financially when they stand to inherit your assets) it may be worth considering converting some assets to Roth while you still can.

Tax Bracket Source - https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets#2024-tax-brackets-and-income-tax-rates

 For Educational Purposes Only – Not to be relied upon as financial, tax, or legal advice.

This information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness, or fairness.  We have relied upon and assumed without independent verification the accuracy of all information available from public sources.6971760RG_Sep26