Editor's note: This is part four of a seven-part series. It dives more deeply into the issue of how tax-deferred saving can saddle your heirs with massive tax liabilities. If you missed the introductory article, you may find it helpful to start here.
AAPL
STZ
TSLA
AMZN
Parents want the best for their children, and many work hard to provide a generous inheritance for the next generation. Unfortunately, the tax bite that can come with inheriting a traditional IRA or other pre-tax savings account can be astonishing, tainting your legacy.
Recall from my part-two article on required minimum distributions (RMDs), the case study of 40-year-old couple who saved $500,000 combined in pre-tax retirement accounts and who continue to max out pre-tax contributions until retirement at age 65.
Despite taking RMDs of $15.6 million from age 72 to 90, the couple's tax-deferred accounts keep growing, reaching $16.1 million by age 90. Let's assume our couple dies at age 90 and the inherited tax-deferred accounts are divided equally between their two surviving children.
Prior to passage of the SECURE Act in 2019, non-spouse heirs typically could calculate RMDs on inherited IRAs using their own life expectancy, which allowed them to "stretch" out the RMD over a much longer period, perhaps 30 years or more. That's no longer the case.
Under current tax law, heirs have 10 years to fully deplete any inherited IRAs, though they can choose how much to take out each year, from nothing at all to everything at once. While that flexibility can be valuable from a tax-planning perspective, it still means that most people inheriting IRAs will have significantly fewer years to take their RMDs, meaning significantly more taxable income during that decade. Recall that RMD income from tax-deferred accounts is taxed as ordinary income.
For the two surviving heirs in our case study, if we assume zero growth in the liability (unlikely) and they take distributions of 10% annually for 10 years in order to smooth income and taxes, each will have $809,105 of taxable RMD income annually for 10 years. This income is likely to hit during their peak earning years, pushing them into very high tax brackets.
Clearly, this is a first-world problem. But do you want your kids to inherit that kind of tax nightmare?
So far this series has looked at how tax-deferred saving can create problems with RMD income, Medicare means testing surcharges and inherited tax liability. My next article will start looking at solutions to these problems.