Do you have a question about investing, how it fits into your overall financial plan and what strategies can help you make the most of your money? You can write to me on beth.pinsker@marketwatch.com. Please put Fix My Portfolio in the subject line.
I am a 74 year old retired widower. After spending 23 years in Canada in public education, my second marriage brought me to the United States where I became a naturalized citizen. She continued to work in public education for another 20 years where she contributed maximum amounts to 403(b) and 457 plans. My pension from both locations provides enough money to cover all my expenses, including holidays and travel. I've invested over $500,000 in after-tax mutual funds if I need “rainy day” money.
Now for my questions: I have about $1 million invested in tax-deferred retirement vehicles. Is there any reason I should keep it? Is it wrong to think about just ripping off the band-aid? By that I mean liquidating deferred tax money and having a very bad tax year. Then I can leave the proceeds to my children free and clear without them having to worry about paying taxes on the inherited IRA.
Thank you!
Mr. T
Dear Mr. T,
Since you're over age 59 1/2, the money you've saved in your tax-deferred accounts is intended for you to use in any way you see fit, so your opinion is what matters most. Sometimes people make financial decisions for reasons other than simply maximizing their tax efficiency, and that's about as common sense as following some mathematical rule.
What's best for your heirs is an interesting question to explore, both in terms of overall dollar value and ease of use for them. Parents' protective instinct often kicks in when they think about the financial legacy they may leave behind. You want to make things as frictionless as possible for your kids and not leave them burdened, but you also want to leave them as frictionless as possible.
Some may wonder: But how can leaving money to your children be a burden? The truth is, it can be complicated. Yes, you can take the money, but inheriting an IRA also comes with unavoidable tax liabilities for the heir. The government requires non-spousal heirs to empty these deferred tax accounts at the end of 10 years and pay the tax due for each withdrawal. There will also likely be required minimum distributions each year, and your heirs will have to track those distributions. This can affect your overall tax burden, college financial aid, divorce settlements, and any number of other financial circumstances.
None of this is a huge burden, but it's not nothing either. It is never wrong to think as a parent of wanting to take care of this for your children. However, if you're worried about whether the math makes sense, that's another story. Probably not, and here's why.
Secure your life jacket first
You have plenty of other money to withdraw for your retirement, but you're still too young at 74 years old. If you live another 20 years and have higher health care costs, you can use other parts of your retirement savings and you may end up missing the huge amount you paid the IRS to withdraw $1 million in one go.
“The first question you want to ask is literally: Can you afford it?” Says Sean Mullaney, a financial planner and certified public accountant (CPA) based in Woodland Hills, California.
“The tax is a real expense, and you don't want to hurt your existing sustainability.”
If you withdraw $1 million from a tax-deferred account in one lump sum, your income for the year will be in the highest federal tax bracket. Since you're filing as an individual, this means all of your 2024 income over $609,350 will be taxed at 37%. Your tax bill will be in the range of $328,000, depending on the rest of your expenses, deductions, credits, and state taxes.
If you do this transaction as a Roth conversion, you'll want to pay the tax out of pocket, which could eat into much of your $500,000 in savings. The money will grow tax-free while you are alive. Then when your heirs inherit, they will have 10 years to withdraw the balance, at which point they will have to pay tax on any further gains. If you pay the tax from the withdrawal and put the balance in a brokerage account instead, you'll start out with less tax and owe it all the time as it grows — and so will your heirs once they inherit it.
Other options for your money
It may be more effective to simply designate your heirs as beneficiaries of your accounts and allow them to inherit what is in your possession after you are gone, paying the tax over 10 years. “It's not that annoying,” says Rob Williams, managing director of financial planning at Charles Schwab.
You can also convert smaller amounts to a Roth IRA over time while you're alive. The key to your decision lies in your current tax bracket and the bracket of your children who will inherit.
If you're currently in a 35% tax bracket and your heirs are in a 22% or 24% tax bracket, it's probably more tax efficient to leave the money in a tax-deferred account and let them take it out and pay tax on it. at their rate once they inherit.
In Mulaney's experience, the opposite scenario is more common — that the elderly parent is in a lower tax bracket and the inheriting child is in his or her higher income years and perhaps in the 35% or 37% bracket. In this case, doing Roth conversions over time during your lifetime might make sense, but it would likely only go up to the 24% income bracket, which would be $191,950 in 2024.
The only caveat is if you are, say, 95 and know for sure that you won't need the funds. However, it is more of an emotional decision than a financial one. “I cringe when I hear, ‘We're going to rip the Band-Aid off,’” Mulaney says. “Even at 95, I would say do it modestly.”
Williams sees these as the two main downsides to transferring your money all at once: You miss out on tax-deferred growth and will likely end up paying more in taxes than if you reduced your tax burden by transferring smaller amounts at once. Lower tax brackets.
“It may actually give them less,” Williams says. “It's an understandable goal to leave this free and clear to them, but the math doesn't make much sense.”
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