Recently I was contacted by a client who had inherited an IRA from her dad who recently died unexpectedly. The IRA was a real gift to her at this time in her life because she was currently unemployed for the past year, had used up all of her retirement savings in her 401k plan, was having problems meeting the payments on her mortgage and credit cards, and was faced with two children needing their college paid for in the next five years. She was also thinking seriously of filing for bankruptcy because of being unemployed; that is, until her father passed away and she inherited this IRA.
Obviously, the loss of her father was a terrific blow to her especially with all that she was going through with her personal financial situation. In addition to offering my heartfelt condolences for the loss of her loved one, I suggested that she had a lot to consider with what to do now that her financial situation had changed dramatically. The IRA was worth $210,000 that she (an only child) was inheriting, but a portion of that might have to go to income taxes, depending on what she did with this money.
As I reflected on this vignette, I realized that many people face these issues every day as loved ones pass on and leave IRAs to beneficiaries. So this is the focus of my blog for this week.
There is good news as well as bad news parts to this, so let’s go through the various issues for my client Lucy and share some information that may apply to you should you be in a similar situation in the future.
First and foremost, IRA accounts and the equity in your home are protected assets in a bankruptcy. This means that you do not have to worry about losing these assets should you file for bankruptcy. They also are not counted in the financial aid calculation. So how Lucy uses the IRA to help her with the various issues she faces means she has lots of alternatives to maximize this IRA to her advantage.
The first thing we needed to figure out was what the status of this IRA was when her father passed away. In Lucy’s case, her father had started taking Required Minimum Distributions (RMD) because he was 73 when he died. However, he had not taken his RMD for the year 2010. Under these rules, Lucy would have to take the RMD for 2010 and receive it as a beneficiary of his estate. The amount for this year would be $8,502. Since her father died in 2010, Lucy has to start taking RMDs using her life expectancy by December 31, 2011. That RMD will be based on using a factor of 34.2 divided into the balance in the account as of December 31, 2010. In future years, Lucy will reduce the factor by one (34.2 – 1.0 = 33.2 in 2012, 32.2 in 2013, etc.) which is then divided into the account balance at the end of each year prior to the RMD period. Assuming the investments in the IRA grow by more than 3% each year, the amount of the RMD will increase each year (100/34.2 = 2.92% for the RMD amount).
Notice that the RMD for Lucy is only $6,153 in the first year, versus the RMD her father was taking of $8,502. This is because Lucy is 20 years younger than her father and is able to stretch out the value of this IRA for her benefit; one of the key benefits of inheriting an IRA. It is important to note that Lucy can take out more each year but cannot take out less than this amount to comply with the rules.
Let’s look at the tax consequences to Lucy of the $8,502 and $6,153 that Lucy receives. The $8,502 was an RMD by her father’s estate and received by her. This is not taxable to her as an inheritance but would be income to be reported on her father’s last return. The $6,153 would be income to be included on Lucy’s 2011 tax return if she waited until 2011 to take this amount out.
It is important to note that Lucy does not need to take out any of this IRA in 2010 but she could take out whatever amount she wants to deal with her financial issues. Whatever is taken out would be includible in her tax return for 2010. Depending on what other income she has and her exemptions and itemized deductions, the tax liability might not be much.
Since Lucy is not presently working, her income in 2010 could be very low. Her itemized deductions would be about $15,000 for her mortgage interest, real estate taxes and other deductible items on Schedule A. She would also have 3 personal exemptions worth $10,950. This means the first $25,950 of income would not be taxable at all. With two children she is entitled to the Child Tax Credit of $2,000. This means the taxable income, after deductions, could be about $13,300 and she would have no tax liability for 2010. Put another way, if she withdrew $39,250 from the inherited IRA in 2010, she would have no tax liability after the credits; the entire withdrawal could be applied to meeting her financial needs and help improve her financial situation.
If she did withdraw the $39,250 from the IRA, the balance at the end of 2010 would be about $179,150, assuming the account earned 4% on the invested balance. This would make the RMD for Lucy in 2011 to be $5,321 versus the $6,153 noted earlier. Hopefully, Lucy will be able to find employment before the end of this year and she will be able to keep her withdrawals to just the RMD amount rather than erode this valuable asset by taking more than the RMD.
If she withdrew more than the $39,250, the tax rate would be 15% on amounts up to another $32,200 before she would be pushed into the 25% tax bracket. So it is important for Lucy to do this planning on what she thinks are the right actions before executing them to understand what the tax consequences are on the amounts she wants to withdraw from the IRA to help solve her financial issues.
What would be different if her father had not started his RMD because he was under age 70 ½ or had already taken out his RMD for 2010? The $8,502 distribution from the IRA would not have been required, leaving that amount in the IRA to grow for Lucy’s use later in her life.
What other options would Lucy or you have with this inherited IRA instead of taking the RMD? You could take out the entire amount in one year. This would add the entire $210,000 to your taxable income for the year. In Lucy’s case, $6,300 would be taxed at 15%, $72,000 would be taxed at 25% and the balance in the account would be taxed at 28%. These taxes would be in addition to whatever state taxes would be imposed on these amounts. This would be a very expensive move for Lucy or anyone else – $38,265 in additional federal income taxes and the loss of the future tax deferral of any future earnings on this IRA.
The impact to you may be quite different than the impact on Lucy – remember Lucy has no income; if you are employed this money would be on top of what you are already reporting as taxable income on your tax return.
Another option that Lucy, and you, would have is to disclaim some or all of this inherited IRA. If Lucy did this, the amount she disclaimed would go to the next eligible beneficiaries (her children). Any required distributions would then be based on their ages, rather than Lucy’s. If the other beneficiaries are younger than you, you would, in effect, be stretching out the potential for tax deferred growth on these assets. Tax rules require you to disclaim assets within nine months of the IRA/Retirement Plan account owner’s death. Be sure to consult with your tax or legal advisor concerning this option. A disclaimer is an irrevocable decision to give up your right to inherit the IRA/Retirement Plan assets.
There are other issues that I discussed with Lucy related to her situation that may apply to you. This includes the commitment she made to fund the education of her children, her credit card debt, the mortgage payments, and her thought of filing for bankruptcy. I will cover those in my next blog.
Francis St. Onge, CFP®
Total Financial Planning, LLC