Let’s talk Inherited IRAs. After all, the majority of retirement money across America is sitting in tax-deferred vehicles like IRAs and 401ks. And that means much of the wealth that will be passed to a saver’s heir will come through tax-deferred vehicles.
It makes sense why. My daughter just graduated from the University of Kentucky. And on day one of her first job, the questions started coming…What is this 401k and should I do it? Of course, my first question back was “Do they have a Roth option?”. They did. And that’s what she went with.
But not every saver has that choice. And certainly those of us who started in our 401(k) decades ago did not have that option. We went to our first job. We signed up for the 401(k). And we started deferring taxes. Those accounts started to grow. We left our first job, and we rolled over the 401(k) balance to an IRA. And then we started a new 401(k) at our new job.
Stop me if you’ve heard this before.
Now, the good news from this pattern is that many savers have amassed a very healthy nest egg. In fact, for many of our clients, there’s a portion of that tax-deferred balance they won’t need for income. Which means there is a very high likelihood that those assets are going to a surviving spouse. And then the kids and grandkids.
Believe it or not, the reality of that - IRA money going to the spouse and then to the kids and grandkids - presents a big opportunity to financial advisors.
These days I’m hearing from more and more experts in our industry that inherited IRAs are the worst possible instrument to pass on wealth to heirs.
Why? Let’s narrow in on two reasons.
The first and most prominent is what the industry is calling “The Widow’s Penalty”.
Married Filing Joint filers enjoy wide tax brackets and higher standard deductions. But after one spouse dies, the surviving spouse must now file as single, usually the next year, unless they qualify for Qualifying Widow(er) status. Many times, the surviving spouse must live on similar income levels. That similar income level, now applied to a very different single filer tax bracket, can mean more income is taxed at higher rates.
Perhaps you’ve heard of the widow’s penalty. But have you ever actually quantified it for your clients?
We have. And the potential impact can be massive.
Let’s look at a couple with an AGI of $100,000. When filing their taxes MFJ, assuming the standard deduction for a married couple, they would have an effective tax rate of 11.3%. If one spouse were to pass away, and the surviving spouse still lived off that $100,000 AGI, the surviving spouse would then be faced with a 16% effective tax rate.The difference between the two, in this case 4.7%, is what we call the Widow’s Penalty. And that represents a 42% increase in the effective tax rate.
Stop the press.
Has anyone considered modeling a 40% tax increase for their MFJ clients? The risk is real. And it’s significant.
And looking at the chart, the highest increase is for the lower incomes represented.
If, as an advisor, you have never thought to quantify the Widow’s Penalty, there is an easy way. Just use Stonewood Financial’s Roth Done Right software. Run a report on their current situation. Then run an alternate scenario, this time with the same (or similar) income levels. But as a single filer. This will quantify the Widow’s Penalty for you and your client.
Now, the widow’s penalty obviously only applies to a spouse.
But what about when the money goes to the kids?
This is a different, albeit equally significant, tax risk for the heirs.
The Secure Act changed things for non-spousal inherited IRAs. Those beneficiaries, unless they meet unique circumstances, are now forced to pay taxes on IRA money inherited within 10 years. Former IRA laws allowed for that tax bill to be “stretched” over their lifetime. But that all changed with the Secure Act.
I’m going to take what seems like a left turn here. But trust me, it’s related.
I’ve been using the term “Effective Tax Rate” when discussing the impact of IRA money on a tax situation. And for married couples, I think the effective tax rate is the rate to use. It’s their IRA money, and the taxation of that money is “lumped in” with all income. So I like to use the effective rate.
But for non-spousal beneficiaries, it’s a little different. Those beneficiaries have their own tax situation established. The inherited money is all extra. Which means for tax impact calculations, the taxes on that money are at the marginal rate. Or even higher if the beneficiary moves into a higher tax bracket because of the inherited assets.
This chart shows the difference between effective and marginal tax rates at various income levels.
Let’s take a 50-year-old couple at the peak of their respective careers. Let’s say they have a combined taxable income of $400,000. And they inherit a $500,000 IRA from a parent who passed away. That means $50,000 of income per year, which they would need to claim over the next 10 years. Their current effective tax rate would be just over 20%. But that high of an income puts them in the 32% tax bracket. Which means the inherited money is all taxed at the margin. Potentially 12% more than what you would think if you’re only looking at their previous year's effective tax rate.
Or perhaps another couple with a husband earning $100,000, whose wife stays at home. That couple inherits a $500,000 IRA from a parent who passed away. That couple who has a current effective tax rate of 11% would pay double that at the 22% tax bracket marginal rate.
These aren’t small risks - they’re silent tax traps that can devastate a family’s financial legacy.
The good news? You can help clients prepare. By modeling scenarios with Stonewood Financial’s reports and leveraging our advisor training, you’ll have the tools you need to clearly demonstrate these risks and present real solutions. To dive deeper into these strategies, check out Stonewood Financial’s reports and training resources.
One thing’s for certain: When it comes to inherited IRAs, it’s important for all parties involved to understand the tax implications and impacts.
