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There was $200,000 left in an IRA Beneficiary Distribution Account (BDA) when my father passed away. I have 10 years to withdraw this money. I am currently at the 35% federal tax rate and plan to earn a similar annual income for the next ten years. If I took the money out all at once, my federal tax rate wouldn’t change, but neither would it if I took it out over a ten-year period. Is there an advantage to keeping this money in the IRA versus withdrawing it now, paying the taxes, and then using it to invest in other financial instruments?
–Brad
At first glance, it might seem like the solution would be to withdraw everything now. The logic is that it would be better for compound growth to occur in an environment where the long-term capital gains tax rate would apply instead of ordinary income tax. This is often the case when you expect your marginal tax rate to change. I don’t think this applies in your case as you expect to be in the 35% tax bracket in the future.
On the other hand, the money invested in the IRA can reduce the tax burden and potentially leave you with more money at the end of the decade. But like so much in financial planning, the answer to your question may depend on whether tax laws change in the future. (And if you need more help exploring questions like these, consider working with a financial advisor.)
A man is considering how to structure withdrawals from an IRA he inherited.
To evaluate the two approaches, we want to compare the after-tax value of the $200,000 at the end of ten years in both scenarios. We can do this by comparing the extreme goals: withdraw the whole now or the whole after ten years. If either outcome is better – and we hold the same assumptions (returns, taxes) constant over the ten-year periods – a variation of both options would yield a similar result, albeit to a lesser extent.
Different withdrawal options may be available to you, depending on whether your father has already begun receiving required minimum distributions (RMDs). If so, keep in mind that you’ll likely also be subject to an annual RMD requirement unless you meet one of the exceptions.
So let’s get started.
First we need to understand how much you should invest in each scenario. If you withdraw $200,000 and 35% goes to taxes, you will have $130,000 left to reinvest. Of course, if you just leave it in the inherited IRA, all $200,000 remains invested.
Next we need to predict how much money is expected to grow over the next ten years. We can choose any annual rate of return to use, as long as we use the same rate of return for each. I chose 10% simply because it is a round number.
In the first scenario, $130,000 would grow to about $337,000 over ten years, assuming a 10% annual return. On the other hand, if you leave the $200,000 in the IRA and watch it grow at 10% per year, you would be left with about $519,000 before taxes.
Finally, we need to calculate the after-tax value of the money in each scenario.
Since you would have already paid taxes on the original $200,000 withdrawal in the first scenario, all we need to do is calculate the capital gains tax you would pay on the investment earnings. If we simplistically and generously assume that the $207,000 gain from the first scenario is treated entirely as a long-term capital gain, you would owe about $41,000 in taxes when you withdraw the money in ten years. That leaves you with approximately €296,000, including the principal amount of €130,000. I’ve used the 20% long-term capital interest rate here, although some of it may only be subject to the 15% interest rate (even if all of that were the case, it wouldn’t change the outcome).
In the second scenario, withdrawing $519,000 at the end of the 10 years would mean paying 35% income tax on the entire balance, leaving you with $337,000 – $40,000 more than in scenario 1.
From a purely tax perspective, there may be a reason to leave it in the IRA for ten years. (And if you need help running the numbers to answer similar questions, consider consulting a financial advisor.)
A financial advisor shakes hands with clients he helps manage an inherited IRA.
Not necessarily. You always want to think about how a particular approach fits into your overall financial plan. You may also want to consider possible variations on the assumptions we made in the scenarios above. Examples of such variations may include:
Your returns may not be the same in every scenario. There will likely be some tax burden on the money invested outside the IRA. Of course, you may also have the opportunity to reap losses.
Tax rates may increase in the future. You might decide to leave the money in the IRA, only to find out in ten years that you’ll be in a new 70% tax bracket. You should also consider how capital gains taxes might change.
Your tax situation may change. You may change jobs, face a layoff, or go through some other experience that reduces your income and therefore changes your tax rate.
The point here is not to introduce unnecessary complexity. Instead, I point out that no matter what the numbers on the spreadsheet say, circumstances can change. You need to decide how you want to interact with those prospects. (And if you need a financial advisor to guide you, this tool can help you find one.)
Tax-advantaged accounts such as an IRA Beneficiary Distribution Account offer some clear benefits for long-term savings. The best way to use them may vary and depends on individual circumstances. This includes current and future tax rates, as well as preferences and assumptions about your income needs in the future.
Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
When hiring a financial advisor, there are some important pieces of information you should obtain before making your final decision. Here are 10 essential questions to ask a financial advisor before hiring one.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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Brandon Renfro, CFP®, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question that you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Brandon is not a participant in the SmartAsset AMP platform, nor an employee of SmartAsset, and has received compensation for this article. Questions may be edited for clarity or length.
The post Ask an Advisor: My Dad Left Me $200,000 in an IRA, But I’m in the 35% Tax Bracket. How should I structure my recordings? first appeared on SmartReads by SmartAsset.
