A possible change in tax law would require heirs of our IRA to fully distribute them over fewer years. The change, described here, (“… It Could cost Your Kids Thousands.”) would require that our IRAs be fully distributed within ten years of our death. Here’s another article that describes the effect as a “confiscatory death tax mainly on … middle-class [and] is egregious.” Will this cost our heirs $thousands? Yup. But is this unfair and confiscatory? I offer my views in this post.
== Two issues are at play ==
1. Under proposed law tax-free growth on my IRA after death would be shortened by decades. As I describe here, the big advantage of an IRA is tax-free growth. You avoid gains taxes – primarily capital gains taxes – on growth of your contribution for as long as you keep your money in your IRA; you’re compounding growth without the drag of taxes. Once you withdraw an increment, you end its tax-free run and then, in essence, all future growth on that increment is taxed at 15% capital gains rates. This lowers your real return rate by 15%. Example: the real expected growth rate of my IRA is 6.34% per year. Once my money is subject to capital gains tax, my expected growth rate is 5.39% (85% of 6.34%). Money compounds to roughly 15% less over time.
2. Under proposed law, our heirs will pay a greater marginal tax than they would under current law. Most of us have Traditional IRAs and small or even no Roth IRAs. I started contributing to my IRA in 1981 and only Traditional was available. Certain types of plans that I contributed to over the years (SEP-IRA) were only Traditional. Roth first became available in 1997, and I had already made the bulk of my contributions. While I have converted some Traditional to Roth, I’m basically 100% Traditional. I’m therefore sensitive to the marginal tax rate I pay when I withdraw. I would like that rate to be as low as possible. I certainly don’t want to bump into a painful marginal tax rate that I could otherwise avoid.
== #1. Tax-free growth: 10 years vs. 80 years ==
Under current law when you leave your IRA to a non-spouse beneficiary, it continues to exist for ~85 years less the age of beneficiary at your death before the final withdrawal depletes it. Last week I used the example of how my IRA existed 50 years in my lifetime and would exist 30 more years for my hypothetical, non-spouse beneficiary age 55. If I had left my IRA to a beneficiary age one, my IRA would have existed more than 80 years after my death! I think of my 1981 contribution: some part of it would grow tax-free for 50 years in my lifetime and 80 years thereafter: 130 years of tax-free growth!
Yes, shortening the maximum number of years of tax-free growth to ten years after my death means that tax-free growth runs fewer years and capital gains tax on growth kicks in earlier.
But I don’t have a problem with this. The idea of my IRA lasting and growing tax-free for 80 years after I’ve died is crazy. Ten years after I’ve died seems much more rational.
Also, Patti and I want our heirs to be able to use money that we can leave them earlier not later – we’d ideally like to get most of what we’d like to leave them while we are alive. I like the thought that they are able to use more money when they are younger. We want our heirs to use what we can leave them to make a difference in their lives SOONER, not later. Maybe they’d use the money for their kids’ education; take far better family vacations; spend to improve their home; or contribute to their own IRAs. I have no problem in them getting it all from my IRA (withdrawing it all) in ten years.
Actually, I recoil a bit at the thought that my IRA is going to hang around for decades after I’m dead and be, in effect, a very large part of an heir’s retirement plan. I don’t see that as our responsibility.
== #2. Income in a higher marginal tax bracket ==
This is the problem of 1) a large initial Traditional IRA that grows because expected returns are well below RMD percentages for many years; 2) RMD percentages that eventually are large; and 3) leaving your IRA to too few heirs. Those factors combine to result in large RMDs for an heir – perhaps so large it throws him (her) into a painful tax bracket that he would otherwise avoid.
• We may have this problem: it’s not limited to our heirs. At expected returns for stocks and bonds, our RMD will be twice our first RMD as I describe here. That’s from the play of factors 1) and 2) above. Example: When I am 82 my RMD (about $73,000 in this example) will be about twice my first (about $36,500). My IRA at age 85 ($1.24 M) is 24% more in spending power than it was at my age 70 ($1 M). Note: Through my age 85 I withdraw roughly $930,000 and have a balance of nearly $1.25 million. Nice result from that $1 million start!
Depending on the size of your beginning IRA, an RMD that is twice what it was at age 70½ could throw some part of your income into a painful tax bracket. The painful transition is from 24% to 32% marginal rate. You keep 11% less on the part that falls into the 32% marginal bracket.
This problem of some part of income falling into too high marginal tax bracket is limited to folks with very large IRAs and therefore very high RMD: the trip point that starts the 32% marginal tax bracket is over $310,000 taxable income for married, joint filers. (That’s nearly $340,000 in gross income.) I think we’d all like to have this problem.
• Under current tax law, my heir will have larger RMDs from my IRA than I will have. I used the example last week of an heir age 55. She may fall in into a marginal tax rate that she really would not like for MANY years.
Her $1.24 million Inherited IRA has 24% more spending power that it had at my age 70. Her initial RMD percentages are well below the expected return rate and her Inherited IRA grows in real spending power. It grows to be much bigger than mine ever was: oh, the power of compound returns and time.
When she is age 66, her RMD ($85,000) will be greater than mine at age 85 ($84,400). When she is 77, her RMD will be double and it will eventually be triple this amount. It gets so big that it alone almost places her in the 32% marginal tax bracket. And this is on top of RMDs she’ll be taking from her own Traditional IRAs and Social Security and other income. Wow!
• My heir will have this problem under proposed law. If my heir has to fully withdraw from my IRA over ten years, she’ll have at least one large withdrawal that will result in very high taxable income. The simplest way to see this is to assume my heir age 55 sticks with the RMD schedule under current law. That means no difference relative to current law for nine years. But then at the end of the 10th year she withdraws the final balance – a total withdrawal of +$1.6 million.
She’d pay 37% tax on taxable income greater than $510,000. (The chart is in $constant and brackets adjust for inflation, so that’s an accurate statement.) She’d keep 63% of the total. If she otherwise would have been in the 24% bracket she would have kept 76% of the total. The added tax cost results in roughly 17% less for her.
My guess is that the impact over ten years is a lot less dramatic than 17% difference. With planning she can lower this impact: withdraw more earlier so less is taxed at that very high marginal rate. I can’t easily compare this to the tax effect under current law because I can’t reasonably estimate the tax impact of those high RMDs for 20 years – her age 66 to 85.
I don’t get agitated about this problem. This affects very few of us in my opinion. This would be a nice problem to have and to work to solve. Also, total withdrawal of your IRA in ten years has much less tax impact – perhaps no impact – if you leave your IRA to more heirs.
Think of this way: you start out with a $1 million IRA. You withdraw +$900,000 to enjoy in 16 years. Let’s assume that’s the balance of your lifetime to age 85. And then your heirs get to withdraw $2.1 million in the next ten years to enjoy in their lifetimes. Wow! I really like that.
Conclusion: Proposed tax law may require our heirs to totally withdraw the total in the IRA they inherit from us in 10 years. That is decades shorter life than current law. Shorter life means fewer years of tax-free growth and an earlier start on capital gains tax on growth. That’s a loss relative to what seem crazy to me: my IRA could exist and grow tax-free for 80 years after I died.
Greater annual withdrawals from higher RMDs could throw (us and) heirs into a marginal tax bracket that they really don’t like. That could happen under current law and proposed law. High marginal tax on withdrawals is an issue for the rare few of us with large IRAs and few heirs.
The bottom line for me is this. You start with $1 million. Under proposed law and expected rates of return, you withdraw +$900,000 to enjoy in your lifetime. Your heirs withdraw $2.1 million over the next decade. They get to enjoy twice as much as you did. You have to like that.