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Military Finances 301: Timing Inherited IRA Distributions After the SECURE Act

Retirement Funding Estate Planning

In a previous blog post, I addressed how the SECURE Act would affect your retirement accounts. To summarize, distributions based on the life expectancy of the person who inherits the IRA have gone away (in most cases) and the distributions must be completed within 10 years of inheriting the IRA. You can take some out of the IRA each year or you can wait until the 10th year and take it all out then. And of course, you can do some combination of these two options. But what option is best?

On its face, you might think that even-flowing the income out to keep yourself in the same tax bracket would be the best idea. I often find when it comes to taxes and planning, what appears as the best option isn't always the best option. So, like I do some times, I decided to open up good old Excel. And I did some of that fancy modeling. I compared what would happen if I took some each year or if I waited until the end of 10 years and took out the entire amount. Here are the assumptions I made:

  • $50,000 was inherited in the IRA
  • In the case where I made distributions each year, the distribution was made and reinvested into a taxable account on the first day of the year.
  • The first year the distribution was one-tenth of the balance. The second year the distribution was one-ninth of the balance and so on.
  • The yearly distributions from the IRA were taxed at 22%
  • Earnings in the IRA were based on the year's starting value and in the case where distributions were made the earnings were based on the value after the distribution.
  • In the taxable account where the distributions were deposited, dividend earnings were assumed to be 3% and were subject to a 15% tax rate
  • Capital gains in the taxable account were the assumed growth rate minus the 3% dividend rate and taxed at 15% upon sale at the end of the 10 year period
  • State taxes were not modeled, but it is unlikely they would have changed the results as state tax brackets are so flat and most states don't give preferential treatment to dividends and capital gains.
  • In the first run, I set the growth rate at 7%

Here is what I found. Your taxes can go up quite a bit and you'll be ahead by leaving the money in the IRA and taking advantage of tax deferral. In fact, your tax rate can increase from 22% to 36% as a result of the lump sum distribution, before taking the distributions over time puts more money in your pocket. As a point of reference, the top tax bracket in 2020 is 37%. The 37% bracket starts at $622,050 for those who file as Married Filing Jointly. The top of the 22% bracket is $171,050. So, if you're at the top of the 22% your distribution would have to be $451,000 before the increased tax bracket would overcome the benefits of tax deferred earnings. I found out some other things as I played with the numbers. Here are a few:

  • The size of the IRA doesn't change the math. You would still need to go from 22% to 36% before you need to worry about distributing over time.
  • The greater the growth rate, the greater the advantage becomes to leave the funds in the IRA. For example, setting an 8% growth rate, the taxes on the distribution would have to increase to 42% from 22% to make taking even distributions over time the better option.
  • The results are generally the same, if you assume a lower tax rate during the 10-year distribution period. For example, with a 12% tax rate on distributions from the IRA and zero taxes on dividends and capital gains in the taxable account, the tax rate on the distribution would have to rise to 30% to make the yearly withdrawals the better option. This assumes a 7% return.

What to Do With this Information?

The first thing is don't go for the obvious solution. I don't think we're wired to accurately assess the impact of tax deferral and compound earnings. Next, if the IRA is very large and will push you up into a bracket that makes waiting a bad idea, then maybe wait until the last 2 (or 3) years to take the distributions. Finally, if you don't like building spreadsheets to model financial outcomes, you might want to talk to a geek that does.


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