By Amber Shrosbree, CFP®

If you have inherited an IRA recently, you may be aware of the changes made in the 2019 Secure Act to Required Minimum Distribution (RMD) rules.  We’ve summarized those in more detail here (So You’ve Inherited an Inherited IRA) and here (Changes to Required Minimum Distributions), so in this case study we are focusing on a non-spouse, non-eligible designated beneficiary scenario.  We believe there is an opportunity for proactive planning when it comes to RMDs for inherited IRA accounts. 

Case

Ms. Smith, age 44, recently inherited an IRA from her mother who passed away. Ms. Smith’s mother had just turned 74 and started taking RMDs, and the balance of her IRA account was about $800,000. Ms. Smith makes $120,000 per year in wages, and for the sake of simplicity we assume that her wages do not increase year over year. She has asked us to invest this account for her, and over the next ten years it will grow by about 6% on average per year.

Ms. Smith comes to us for advice on how to handle her inherited IRA. Her current plan is to take only her RMD each year until the final year when she will withdraw the balance of the account. Her reasoning is that it seems to be the simplest and least costly way to handle the taxes due, as she will be taking as little income from this account as she can for as long as is permitted.

While Ms. Smith would not be penalized for this approach and it is technically one correct way to take her distributions, we also see it as unnecessarily costly. Instead, we suggest an alternate recommendation where she takes equal distributions every year from the account:

Assuming her inherited IRA is fully invested and she needs to have it emptied by the tenth year, Ms. Smith will need to withdraw about $93,000 per year. That withdrawal combined with her wages puts her in the 32% tax bracket, since she is filing single, with a total federal tax of about $43,000.  Multiplying that tax by ten years results in a total tax bill of about $430,000.

Next, we review the approach she had in mind to compare:  

If Ms. Smith were to only take the minimum required distribution each year, by the end of the tenth year it will have grown to about $1,165,000. While her tax bill each year for the first nine years is only around $20,000 to $25,000, the tax bill for that final year comes out to be around $431,000 due to letting the bulk of the account continue to grow. All of a sudden, Ms. Smith jumps from her usual 24% federal tax bracket to being in the 37% bracket. The total tax burden over those ten years comes out to be about $650,000, 66% of which she has to pay all in that final year.

By taking more income sooner, she is able to spread out the tax burden and actually pay about $220,000 less in taxes.

Keep in mind that this is a simplified case in order to display the value of tax planning when it comes to the 10-year rule. For example, we have not included the effects of inflation or of time value of money. And there are countless nuances that can be added to this case that could change the outcome and even our recommendation. The point of this is to show that although you might be tempted understand this rule to mean you have 10 years to address it, it is in your best interest to be proactive and do more than minimal planning for your inherited IRA distributions.

Everyone’s individual circumstances vary, and a Financial Planner can be a great resource when it comes to understanding the complexity of Required Minimum Distributions and your Inherited IRA. If you think that you could use some counsel in this area, feel free to give us a call at (714)738-0220, or visit our website to schedule a complementary call at eclecticassociates.com.