Traditional Individual Retirement Accounts and Roth IRA accounts are extremely important. At the end of 2021, they held $14 trillion in assets. DWM readers know that, in the right circumstances, we love Roth IRAs. With Roths, you pay the tax once and the funds grow tax-free “forever.” Of course, it’s not quite that simple. IRAs and Roths both provide lots of opportunities and come with very specific rules that need to be followed to avoid extra taxes and expensive penalties. Let’s talk about some of those today.
Clarification of Distributions for Beneficiaries of Inherited IRAs. Generally, when the first spouse dies, the IRA is transferred to the surviving spouse, if one exists, who takes RMDs (Required Minimum Distributions) based on the Survivor’s Age. Inherited IRAs are generally those IRAs left to individuals other than the spouse.
Let’s assume Mom and Dad both die at age 90 in 2023 and leave $500,000 in traditional IRA accounts and $500,000 in Roth accounts to their two children, one age 65 and one 60 years old, split evenly. The Roth money can continue to grow for 10 more years with no requirements to take any distribution until the day before the 10th anniversary of the second parent to die. If the Roth funds in total grow at 6% per year, that’s $900,000 income tax-free for the beneficiaries to split in 2033. That’s wonderful and easy.
It’s not nearly so simple or tax friendly with the traditional IRA. The money needs to be all distributed within 10 years from date of death of second to die, but, if the owners (Mom or Dad) had been taking RMDs there needs to be annual distributions during the 10-year period, based on the beneficiary’s age in the first year of distribution (the year after Mom and Dad had passed) of the “inherited IRA.” This rule was clarified recently as the IRS originally said that traditional IRAs had to be fully distributed in ten years but there was some ambiguity over distribution requirements in years 1-9. The current regulations apply to 2023 and beyond.
The annual distribution amount is based on Table 1, Appendix B of the 2022 IRS Publication 590-B. Basically, the beneficiary uses a number that is very close to their age in distribution subtracted from Age 87 (typical life expectancy). So, a 65 year old would use a divisor of roughly 22 (87-65), a 60 year old, a divisor of 27. In year one, distributions in our example, assuming a starting value of $250,000 each for our two beneficiaries, the older child has to take $11,363 ($250,000/22) and the younger child $9,259 ($250,000/27). In year two, the divisor is reduced by one. So, the older child’s divisor is 26 and the younger child’s is 21 and the distributions are likely a little larger. By year 10, all funds must be distributed. Many times, the most tax-efficient distribution method is to take equal payments over 10 years.
The special rule is that if the original owner of the IRA died before they had started RMDs, then the inherited IRA beneficiary is still required to distribute the entire amount within ten years, but there are no requirements of earlier distributions as described above. This is why a Roth IRA, which has no RMDs for the original owner or spouse, has no distribution requirements until the end of the ten-year period.
Retirees can earn Money for life by giving to Charity. DWM blog readers know we really like QCDs (“Qualified Charitable Distributions”) for those that want to make tax-efficient donations. Here’s an earlier blog that includes information on QCDs. IT'S THE PERFECT TIME TO HELP YOUR COMMUNITY | Detterbeck Wealth Management (dwmgmt.com). The new wrinkle starting in 2023 is that if you are over 70 ½, you can now earn money for life by making a special QCD gift. It’s a win-win. You can give your charity up to $50,000 in lifetime contributions from your IRA and get monthly distributions each year back from the charity. The qualified gift is a QCD (not-taxable), however the payments received are taxable income. Donors can elect payments made over a period up to 20 years or for life. No surprise, donors in their 90s, who elect lifetime payments, get the largest payouts (up to 9.7% annually). The economic impact is at least a small portion of the QCD remains with the charity as up to 90% of the value may come back to the donors based on actuarial tables.
Unspent 529s Converted to Roth IRAs. What do you do when the kids are through college or even post-graduate work, and there is still money left in the 529(s)? Yes, you can take it out and pay tax on the earnings on your contributions along with a 10% additional tax on any early (before age 59 ½) distributions. But, if the 529 has been maintained for 15 years, how about converting $35,000 of it into a non-taxable Roth account for the beneficiary, one or more of your children? The transaction is tax-free and the Roth money grows tax-free “forever.”
Again, there are very specific rules. The $35,000 is a lifetime amount and not an annual amount. The amount converted from a 529 plan in a given year is subject to the regular IRA contribution amount for a year, such as $6,500. The amount converted must “bake” for 5 years in the 529 before rollover. Good news, though, there are no Roth modified AGI limits that apply.
Conclusion. Traditional IRAs and Roth IRAs (and for that matter 529 plans) are generally a very major aspect of your financial planning. Opportunities and rules related to them are ever changing. We recommend you work with a total wealth manager, like DWM, who understands how best to use these significant assets in the most appropriate way to maximize growth and minimize income taxes. Please give us a call if you have any questions on these important matters.