I didn’t expect to be writing this blog post for another twenty years, but here I am. A significant connection between my Dad and me was our shared obsession with tracking our assets. He managed his own money, and while I disagreed with some of his strategies, he was also too focused on working to develop a more advanced retirement plan.
When you are retired, you want to take advantage of having a low income. This places you in lower tax brackets, and if your “income” is only from long-term capital gains, you can literally pay 0% in taxes. However, if you have non-Roth retirement accounts, you have to start taking withdrawals when you reach the age of 73. This money is treated as ordinary income. You may also be receiving Social Security, which can also be counted as income.
As I have talked about previously, you want to avoid having non-Roth IRAs when you retire. When you reach the age of 73, you have to start taking Required Minimum Distributions (RMDs). Guess what age my Dad died at? 73.
Gotchas
You may already know this, but upon death, many financial assets receive a “step-up in basis.” If your parents bought a house for $100K, and it is now worth $500K, upon their death, it’s as if you bought the house for $500K. This means if you sell it, you don’t have to realize a $400K taxable gain.
The same thing happens with a brokerage account. If your parent bought $10K of Apple stock that is now worth $100K, you don’t have to pay tax on the $90K gain when you sell it.
An IRA is not like this. Everything in there is pre-tax money. You can do whatever you want with the assets inside, but it doesn’t matter what the purchase price of the stocks was. What matters is how much money you withdraw from the account. This amount will be treated as ordinary income at your tax bracket.
Here’s the catch: if this is an inherited (non-spouse) IRA, you have 10 years to withdraw all the money from that account. This means you are going to be hit with income tax for at least one of those years, and likely more.
Here’s the worst catch: if the original account holder was taking RMDs, you, the beneficiary, must also continue to take RMDs. That means if you have FIREd and are living in a low-income world, you’re now going to be forced to take income tax hits whether you want to or not. Also, if the deceased did not satisfy their RMD for the year they died, you have to fulfill that RMD withdrawal before the end of the year.
Penalties
I don’t want people to think that I am complaining about inheriting money; I am grateful for what my father left for my family. Everyone should be excited to inherit an IRA. For the average American, you should be able to pay off some debt, get yourself a nice gift to remember the person by, and then save for your own retirement by depositing the rest into a Roth IRA.
However, as a person who has FIRE’d and is looking to keep their income as low as possible, my brain immediately goes to, “What if I don’t take this income?”
There is a 25% penalty for not taking a required RMD. And if you don’t take out all the money by the end of the 10-year period, you face another 25% penalty on the full amount still in the account. So, unless tax rates change dramatically, you absolutely must withdraw everything within 10 years. However, a case could be made for strategically not taking the annual RMDs in certain years, even with the penalty.
One major reason to avoid this income is if you are receiving financial aid for college. The inherited IRA itself is typically excluded from FAFSA and CSS calculations, as it is a retirement account. However, once that money is withdrawn, it not only counts as increased income for that year but also increases your reportable assets. A potential double-whammy for financial aid.
The other reason is healthcare. If you are receiving ACA subsidies or are on Medicaid, the income increase could change your costs significantly.
Finally, managing your tax brackets can come into play. Maybe you are currently at the top of the 24% tax bracket, and the RMD income would be taxed at 32%. That additional 8% tax savings might help ease the pain of the 25% penalty. There are also state taxes to consider. Maybe you plan on moving to a no-income-tax state and want to avoid paying another 5% or more.
Taking the RMD penalty is still playing with fire, as you still have to withdraw everything within 10 years. The size of the inheritance and your current income play a huge role. If it is a relatively small inheritance and you have an average income, you should probably take even distributions, try to stay in the 24% bracket, and just move on. If you have a high income, I would think about withdrawing everything immediately to give yourself more future flexibility.
More Planning
For my specific situation, I’m going to need to think about our future sooner than I expected. We live in Illinois, with a 4.95% flat income tax and a 2.07% average effective property tax rate. This is not a state where you want to be realizing significant income or owning a large home. We also have one child applying to colleges and a second who is four years away.
I am torn between not worrying about money anymore, since I already had enough to FIRE before the inheritance, and feeling the need to be even more careful because we have more to manage. But the truth of the matter is that I enjoy playing the finance game.
