Paul Winkler: Welcome. This is “The Investor Coaching Show,” and I’m Paul Winkler, talking about money and investing. We talk about all things investing here on this show and financial planning and retirement planning. Michael Sharpnack, Chartered Financial Consultant and retirement income certified professional is here with me.
Tax Law Changes
Okay, so one of the things that has happened in recent years is we’ve had some tax law changes. And in particular, one of the things that has changed is the IRA inheritance rules. So, Michael, talk in general, what’s going on there?
Michael Sharpnack: So for a long time, the inherited IRA rule, so you have maybe a parent that has an IRA. They pass away and that now goes to you. It’s called an inherited IRA. It used to be that you could stretch that amount out over your lifetime. So if it’s $100,000 and you got 30 years. Let’s say the government says you have 30 years left. They’re going to take a little bit out over that 30-year period.
PW: Yeah, the first year it’s going to be 3.3%, so it’s going to be one-third. If you look at that 30 years and you take your account value divided by 30, that tells you what your distribution is going to be. In that particular case, it’s going to be very, very low. And then each year as you get older, they’re going to subtract one year from your life expectancy. Pretty simple.
So it’s 30 one year, 29 the next, 28, 27, and if you’re still alive 30 years hence, you’ve lived past your life expectancy, the account will be emptied. If you had any good sense, you would’ve passed away. That’s one way of looking at it—a warped way of looking at it.
MS: That’s gone. Yeah, so now they’ve changed it to a 10-year period. They’ve really made it more complicated. Now all the money has to come out within 10 years. There’s still regulations that we’re waiting on for them to come out. So they haven’t clarified everything with it yet. But the big change there is now it’s a much shorter period, so you’re having to take more out faster, which means more taxes. Everybody’s worst enemy.
The government isn’t as patient as you think.
PW: And the government’s basically saying, “We’re not necessarily as patient as you think we are.” So you’re going to actually have to pay tax. And for significant size accounts, when you’ve got a very large IRA, that can be fairly significant. And hence the reason that some people are looking at how to do this. What is the account value? Is it a really, really large IRA? How many inheritors? So that would be one thing you’re going to look at.
If you only have one beneficiary for your account, you could be looking at, let’s say a million dollar account. And if you do a 10th the first year, because you’re going to do this over a 10-year period, you’re looking at a $100,000 distribution. That’s going to be on top of their taxable income. And if they already have a fairly decent taxable income, you could be looking at easy getting up in that 37% rate and 37% of the distribution goes to the government and it wasn’t necessarily who you wanted to inherit the money.
So look at how many beneficiaries. The more beneficiaries that you have, then the lower the amount of that distribution, because you have a lot of different people that are going to be taking that money. So if it’s a million dollars, let’s say, and you’ve got 10 beneficiaries, now you’ve got $100,000 each, and now it’s only a $10,000 distribution, in my example, you see?
Exceptions to the 10-Year Rule
So it’s a much bigger difference. So that’s one consideration. So in essence, there is the 10-year rule and there are some exceptions. So what exceptions do you typically point out to people regarding who is not going to be held to that 10-year rule?
MS: Yeah, so the first one is a spouse. If you’re inheriting from a spouse, it just rolls over into your own IRA. So that’s the easiest scenario. The next exception is if you have someone that’s not more than 10 years younger than you,
PW: So you’re 73 years old and the person inheriting your IRA is not your spouse, but they’re 65. So they’re not fully 10 years younger than you or more. And so hence they are not going to be subject to that 10-year rule in this particular case.
MS: Right. And then someone who is disabled, according to the IRS definition of disability, which there’s still some regulations and rules coming out around that, and then a minor, considered a minor, they’re not subject to the 10-year rule either.
PW: And what happens, and some little clarification on the minor. One of the things that you recognize with a minor is this. So let’s say a seven-year-old has to inherit this thing. They have to take required distributions based on their life expectancy, but for a seven-year-old, you got a long life expectancy. So the distribution is very low, and then you wait until they reach the age of majority.
There’s been some debate about that. Do we use the federal, what state, do we use age 21? Do we use age 18? Because it depends on the state. A lot of talk about it being 21, and then you start taking distributions at the 10-year rule at that age 21. And then there had been some speculation regarding if the person is a full-time student. That’d be something, be eyes wide open if that’s your situation, be watching the rules as they come out regarding that.
Watch the rules as they come out.
But in general, they have the 10-year rule for that young minor is not going to be upheld or they’re nine years old and they’ve got to have it all distributed by the time they’re 19. That’s not in the spirit of the rule regarding that.
Strategies to Mitigate Taxation
PW: Okay. So let’s say that we’re looking at this and saying, “Man, I’d really not want to pay taxes on this. Is there any way that I can get around it or any strategies that I could use?” So just talk a little bit about some of the strategies that might be used to bypass, let’s say, taxation or to mitigate that to some extent?
There are a lot of options out there for mitigating taxation, and it’s going to depend on your specific situation.
MS: Yeah, so there’s a lot of different options here, and it’s going to depend a lot on the specific situation. So how much longer do you plan on working? What’s your income? Is there any fluctuation in your income? What other assets do you have? Are there non-qualified assets? Are we looking to delay social security benefits? There’s a lot of other variables that we’re going to all piece together to start to put a plan together.
But one common strategy, and we’re doing this a lot, especially as you reach retirement age, your parents are getting older and that’s when people are starting to inherit more assets as you approach that age.
PW: Right, right. So when that happens, you look at it and go, “Well, I’m taking a distribution.” One of the things we’re going to look at is do you have a retirement plan at work? Do you have a 401(k)? Do you have a 403(b)? Do you have a 457? Do you have a simple plan? Do you have a SEP? Most people do not max out those programs.
Matter of fact, it’s hard to get them to even put small amounts in the 401(k)s, sometimes getting them to put more than 5% of their pay away. But you have the maxes that you can get in there, and if you’re over the age of 50, $30,000, so you’re looking at, some people are maybe only putting like $5,000, let’s say, in their 401(k), and they can put $30,000, and you go, “Well, I got this distribution. What if I live off of the distribution from the inherited IRA and take that income and actually live off of it and then defer more of my own personal income?”
So let’s say that I’m getting a $10,000 distribution and I’m only at $5,000. And I go, “Well, why don’t I defer? I’m only deferring $5,000 of my income? And that $10,000 I’m getting from the inherited IRA, I’ll just live off of that.” So my standard of living hasn’t changed, but basically what I’ve done is I’ve taken a taxable distribution and I’ve made it a non-taxable event in that particular case.
MS: Right. And the reason because you can’t just contribute the money from the inherited IRA into a tax deferred account really straight away.
The IRS is like, “No, you got to take the money out because we want our taxes.” That’s the whole reason for this rule. So this is kind of a way to get around that a little bit. It seems kind of weird because what you might actually be doing is within a couple days, you have a distribution coming out of your inheritance into your checking account, and then you have money coming out of that checking account into a retirement account. So it just has to go to that stop at the checking account so the IRS sees it.
IRAs and 401(k)s
PW: And it’s coming to you because you’re going to be able to spend it. And what’s happening is your paycheck drops significantly, is what ends up happening. So you’re going to see your paycheck go way, way down. You go, “Oh.” Then you go, “Oh, wait a minute, I got money in the bank account because I got that inherited IRA money that’s sitting in that account.” And then you can basically offset the tax deduction of the contribution to the retirement account with the distribution from the inherited IRA. So that’s the idea behind that.
MS: Right, right. Yeah. With a 401(k), and if you’re self-employed and maybe you don’t have a 401(k), that’s where you can set up your own plan, because maybe you’re contributing to an IRA, but the max is only $7,000, that you might move to a different type of plan, a simple IRA or a SEP, depending, which you can actually contribute more. And then it kind of works like that where it’s coming into your account and going right back into this one.
PW: So that may be confusing to a couple of people. People say, “Well, what’s the difference between an IRA and a 401(k) and a 403(b) and those types, and a simple plan and the SEP plan?”
Contribution limits are really what the difference is between IRAs and 401(k)s.
So which one is best for you?
Well, if you’re working for a company and that’s what they’ve got, 401(k) or something like that, 403(b), if you’re a nonprofit or something like that, 457, you’re working for a governmental organization, you may have that. That’ll be what you’re putting the money into versus if you are self-employed. If you don’t have any type of plan available to you and you’re not self-employed, an IRA may be the only thing you can do. Or you may, in some instances, do both.
Some people are able to do both. That might be another thing. You might do a 401(k), and then because your income limit is low enough, you can actually do an IRA, as well. So there are all kinds of things that you can do to shelter some of this in an indirect way to protect yourself from the taxation of that inherited IRA money.
Now, IRAs, 401(k)s, and those types of things are creditor protected, whereas inherited IRA, you don’t have that. So one of the things to keep in mind is that you don’t necessarily have that creditor protection. So it’s not as beneficial.
That’s one of the things people forget about, I find. They don’t recognize that these qualified plans, you’re protected against creditors and they can be a good way to protect your assets, because you see these asset protection workshops and the hoops that people jump through to protect themselves. But that’s a good little thing out there. So what other types of things that you’d think, Michael, anything else that you think of strategy-wise?
How Much Income Are You Making?
MS: Yeah. Well, one of the big questions, like I mentioned earlier, is how much income are you making? Because the strategy we just talked about really comes down to making enough income where I don’t want to have any more because I’m just paying unnecessary taxes. But maybe there’s several different scenarios where maybe your income is low for a year.
Yeah. And there could be lots of different reasons. Maybe there’s high business deductions, maybe you’re just in job transition. There’s different reasons. Another strategy, we could intentionally make your income low if you’re not working and you’re kind of nearing retirement, just working part-time, we can live off of non-qualified assets to make your income low for a year and do something. So anyway, there’s different reasons why your income might be low, but in that case, if your income is low, which is relative really. It’s relative to what you’re normally making.
PW: Make your life easy, get married filing jointly, and then everything else that you’re here, just basically kind of cut it in half and it’ll be good for you.
MS: Typically, right now we’re looking at the 12% bracket. If you’re in the 12% bracket, which goes up to married filing jointly about $110,000 of total income.
PW: That’s right. Yeah. So your first $30,000 approximately, I just round now, I’m just getting to the point where it’s just easier to round about to $30,000 of income. You don’t pay any taxes because of your standard deduction, or if you’re itemizing, it could be higher than that. So you’ve got income that is no taxes.
So if you’re below that level, “Wow, yeah, I can take some income from this inherited IRA and I won’t have any taxes on it.” And then if you have another $20,000 for everything above $30,000, so getting close to about $50,000, then you’re going to be sitting at about 10% tax rate on any of that money. That’s pretty low. I mean, when you look at history, good grief, that’s very low. And then you get above that level and you’re getting to 12%. So that’s where we look at it and go, “That’s kind of a no-brainer, easy low tax rate.”
Think strategically.
So it might not be so harmful to take the income from the inherited IRA, not necessarily do some of these strategies we’re talking about, or maybe even stick some of the money in Roth type of investments. And you’re not trying to avoid the taxation, you’re just going, “Hit me with it” because 10% isn’t bad and 12% isn’t bad. Therefore, when you put the money in the Roth, then it grows without tax and you don’t have any taxes on it in the future.
There are a couple ways that that’s beneficial. Not only no taxes on it, but no effect, as the tax law stands right now, on social security. So you can actually help yourself against social security taxation, as well, what we call the torpedo tax. So that’s a really good point. That’s something strategically that you might be thinking about. What other things that come to your mind, anything else that hits you regarding this at this point?
Non-qualified Accounts
MS: The only other thing there, just along with what you said, yeah, you might take that as income, you might contribute to a Roth, or you might just move it directly into a non-qualified account, which at that point you’re paying taxes, but you’re keeping it invested in that type of account, which can have advantages later on.
A non-qualified account doesn’t qualify for regular tax breaks.
PW: Define non-qualified for me.
MS: Yeah, yeah, exactly. So a non-qualified account, it doesn’t qualify for any of those regular tax breaks like an IRA, and basically it’s going to be taxed on basis. So the amount that you put into the account, say you put $100,000 into it, okay, you’re not going to be taxed on that. You’re just going to be taxed on anything that it earns. So interest, dividends, and capital gains that come out of that account is what you’re going to be taxed on. So it ends up being less, much less taxes than a traditional IRA.
PW: Yeah, it certainly can be. And that is because the capital gains tax rates, if you hold something for more than a year, it can be 0 If you’re in a 10% or 12% tax bracket. If you’re in a higher bracket, 22%, 24%, it can be 15%, which is much lower than 22%, obviously. And even if you’re up in the 37% tax bracket, you could be down at a 20% rate and small surtax you can end up with.
But in general, you look at that as historically, capital gains tax rates have been much lower than regular federal income tax rates in our country, and you have access to it.
If you need to pull money out for some other purpose before age 59 and a half, you don’t have those penalties, and you’re not limited as to how much you can put in it either. They don’t tell you, “You can’t put more than this much in a non-qualified account.” So there’s a couple of good reasons to check that out.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
