Inherited IRA vs. 10-year IRA Distribution: Tax and Net Worth Implications
What are the tax and net worth implications of a 10-year IRA distribution compared to the inherited IRA stretched over a lifetime?
Previously, I looked at the CRUT as a Stretch IRA Alternative.
Next, I pondered Life Insurance vs Roth IRA as a Stretch Replacement.
Finally, I discussed the 10-year Rule and your Retirement Accounts to summarize.
In this piece, I’d like to understand the tax and net worth considerations when you consider an Inherited IRA vs a 10-year IRA distribution.
Distributions of Inherited IRAs
The SECURE Act will force an Inherited IRA to be distributed over 10 years. There are no more RMDs (Required Minimum Distributions) from an Inherited IRA that allow it to be “stretched.”
You can take the Inherited IRA out as a lump sum on year one or year 10 if you wish, however there are tax implications! This inherited deferred income sits on top of all your other income. You pay taxes at your highest marginal tax bracket.
Let’s compare a 10-year distribution vs an inherited IRA of old. How much more do you pay in taxes and at the end of it all, how does this affect your net worth?
Effect of Income on Net Worth: Inherited IRA vs 10-year Distributions
Let’s look at a single person with income of either $100,000. I assume spending in each case was 50% of pre-tax income.
Figure 1 (Line graph demonstrating net worth over time for Stretch IRA vs. 10-year distribution)All three lines start at $500,000 of net worth, but already by year 5 there are major differences.
The 5-year distribution has already paid all of tax burden of the inherited IRA.
The 10-year distribution is more tax efficient for the first 5 years, but still has 5 more years of increased tax payments which cause it to lag between 5-10 year compared to the 5-year distribution.
The old fashioned inherited IRA does best in the first 5 years as there is minimal taxes paid on the smaller distributions. Also note, over time, the slope of this line is higher than either of the other accounts, as the bulk of the money remains in tax-deferred status, whereas the income resides in the taxable brokerage account in the other two scenarios.
Let’s look more closely at the required distributions and remaining IRA balance after 10 years.
Comparison of IRA Distributions and Inherited IRA Balance
Old Inherited IRA:
- Distribution increases from $11,450 to $38,360 over 20 years
- Balance after 20 years $989,382
10-year IRA Distribution
- Distribution $55,000 – $89,000 over 10 years
- Balance after 10 years $0
5-year IRA Distribution
- Distribution $110,000 – $130,000 over 5 years
- Balance after 5 years $0
Note the size of distributions.
For the old Inherited IRA, take distributions per IRS required minimum distribution (RMD) tables. For this 40-year-old, her initial RMD on the $500,000 inherited IRA is just over $11,000. After 20 years, she is only taking just over $38,000 a year and the remaining balance in the IRA has almost doubled. This is the real advantage of the stretch IRA. Small distributions allow the inherited IRA to continue to grow in tax-deferred status.
Distributions for the 10-year can be whatever you desire. In this scenario, I assumed the IRA was invested in an 80/20 portfolio returning 7% for stocks and 3.5% in bonds. This return is a continuous 6.3% a year, so I used the minimum initial withdrawal that would deplete the account after the specified number of years, and increase the initial amount by 6.3% a year.
This winds up being an extra $55,000 – $89,000 to pay taxes on for 10 years, or an extra $110,000 – $130,000 to pay taxes on over 5 years.
Of course, the inherited IRA value is zero after 5 or 10 years of large distributions.
Net Worth for Different Income Levels over 20 Years
For those of you who like the numbers, here they are.
If you don’t like numbers, skip this section and go on to the next.
Figure 2 shows the income on the top left of each box. The various distributions are on the top and the number of years on the left.
So, we have seen the story line. What is root cause of the differences?
Let’s dive in even deeper to look at the key tax components of these effective tax rates.
Key Tax Components of Adjusted Taxable Income
The salary in dark blue is just under $100,000. On top of that, note the slow increase the light blue representing investment income from the brokerage account. Finally, distributions from the IRA are in orange.
On top, with 5-year distributions, the total income starts around $200,000 and increases for 5 years as the inherited IRA is depleted. Income from the brokerage account starts at year two and slowly increases over time.
In the middle, note the 10-year distributions. Here, the total income starts around $150,000 and increases to $200,000 over 10 years. Income from the brokerage account starts later than in the 5-year distribution.
On the bottom, the income from the old inherited IRA slowly increases over the 20 years and continue on in retirement. Total income here starts just above $100,000 and doesn’t reach $150,000 until 10 years later. Income from the brokerage account stays tiny as well.
Conclusion: Inherited IRA vs. 10-year IRA Distribution
In conclusion, a 10-year distribution is similar to a 5-year distribution, and both are worse from a tax and net worth prospective compared to the inherited IRA.
The old inherited IRA will be missed. Not only do you pay less in taxes early on, you also get to keep the bulk of the money growing in tax-deferred status. This allows for massive inter-generational wealth transfer from retirement accounts.
Now that the Secure Act has passed, you will be forced to do a 10-year distribution from your inherited IRA rather than the old inherited IRA. This means less money for you now (due to current taxes) and in the future (due to loss of tax-deferral).