One blog I keep an eye on is Michael Kitces’s website Nerd’s Eye View. The content is rarely very relevant to me personally, but they do a terrific job digging deep into tax planning strategies and IRS rulings, so you can at least learn the outlines of an issue before doing your own research. The latest post, Strategies To Mitigate The (Partial) Death Of The Stretch IRA, contained two suggestions so interesting I wanted to pull them out and explore them further.
The issue: many inherited IRA’s have to be completely distributed within 10 years of the account owner’s death
In order to raise revenue to pay for provisions like the SECURE backdoor into 529 assets, the law also requires certain inherited IRA’s to be fully distributed within 10 years, technically by the end of the 10th year following the account owner’s death. Many beneficiaries are excluded from this requirement, the most significant of whom are spouses and minor children of the original account owner. Spouses are entitled to treat inherited IRA’s as their own, while the 10-year clock begins for minor children only once they turn 18. For particularly unlucky orphans, that translates to a distribution window as long as 28 years. Note that no relatives except spouses and children are eligible for this treatment, so you can’t pass an IRA to a minor grandchild in order to extend the distribution window.
For everyone else, the 10-year distribution window raises revenue in two ways. For inherited traditional, pre-tax IRA’s, taxes are owed when distributions are taken. By shortening the distribution window to 10 years, heirs have fewer opportunities to elect to take taxable distributions in particularly low-income years.
For inherited Roth, after-tax IRA’s, while distributions continue to be untaxed, forcing assets out of untaxed accounts mechanically expands the overall base of taxable assets, if for no other reason than making taxable previously-exempt dividends and capital gains distributions.
Jeffrey Levine over at Nerd’s Eye View makes two extremely cunning suggestions for minimizing this eventual tax burden, which I want to strip down and explain as simply as possible.
Split IRA’s between spouses and heirs
The key to this trick is that the 10-year distribution window is triggered anew each time an IRA is inherited. That means passing 100% of your IRA balance to your spouse (who is exempt from the 10-year distribution window), who then passes 100% of their remaining IRA balance to your children (who are subject to the 10-year distribution window), creates a single 10-year distribution window on the death of your spouse.
Alternatively, designating part of your IRA to be passed directly to your heirs (triggering the first 10-year distribution window) and part to be passed to your spouse means than on the death of your spouse a second 10-year distribution window is created. Of course, the second window might overlap with the first, but in the case of a spouse that survives more than 10 years after the account owner’s death, this strategy could extend the total distribution period for your heirs to up to 20 years.
Tax-sensitive allocation of pre-tax and Roth accounts (some math required)
This strategy is somewhat more complicated, but may be worth considering for folks whose heirs pay taxes at radically different rates. Consider the case of an account owner with $100,000 in IRA assets: $50,000 in a traditional IRA and $50,000 in a Roth IRA. The accounts are invested in identical asset allocations. The parent has two children, one in the 10% federal income tax bracket and one in the 37% federal income tax bracket. How should they designate their account beneficiaries?
One suggestion might be to designate each child as an equal beneficiary for each account. Since each child receives an equal share of the parent’s assets, there could be no possible complaint of preference or unfair treatment. The problem is that the $25,000 in inherited Roth assets is worth much less to the low-tax heir than to the high-tax heir, and the $25,000 in inherited pre-tax assets is worth much less to the high-tax heir than the low-tax heir!
This is like leaving your tennis rackets to your daughter who loves to ski and your skis to your son who loves to play tennis. They’re not worthless, but they are worth less.
Alternately, you might consider leaving 100% of the Roth account to the high-tax heir, and 100% of the pre-tax account to the low-tax heir. However this, too, is an imperfect solution, since the high-tax heir will receive the entire after-tax amount while the low-tax heir will receive only 90% of it. We can do better.
Fortunately, it’s relatively easy to calculate an appropriate tax-sensitive beneficiary allocation:
- Start by allocating 100% of the Roth balance to the highest-tax heir. In our example, the high-tax heir starts with a $50,000 allocation, worth $50,000;
- Then calculate the after-tax value of the pre-tax balance for each remaining heir. In our example, $50,000 is worth $45,000 to the low-tax heir.
- Finally, move the Roth allocation to equalize the after-tax treatment for each heir. In this case, the low-tax heir would receive $50,000 in taxable assets and $2,500 in Roth assets, while the low-tax heir receives $47,500 in Roth assets.
Now let’s do a way more complicated example. Imagine the same $100,000 in assets, split between the same traditional and Roth accounts, but now to be passed on to 7 heirs, one in each of the 7 federal income tax brackets. The procedure is the same:
- Allocate 100% of the Roth balance to the highest-tax heir.
- Divide the pre-tax balance equally among the remaining heirs, while calculating the after-tax value for each: $7,500, $7,333, $6,500, $6,333, $5,666, and $5,416.
- Reallocate the Roth so that, each heir, including the highest-tax heir, receives an after-tax total of $12,678.
Please note that this is not literally tax-optimal. A truly tax-optimal beneficiary designation would individually weight pre-tax balances towards low-income heirs and Roth balances towards high-income heirs, and would include state and local income taxes. However, this procedure is simple enough that anyone can do it at home, and of course if you want a more sophisticated or more tax-sensitive beneficiary allocation you can and should hire a financial advisor to make the necessary calculations.