Q: I've inherited an IRA ($75,000) as a result of my Mother's passing. I will get another $30,000 from the sale of her home when it sells, hopefully within the year. I have student loans for a total of $44,000 at interest rate of 7.75% (already consolidated). I am 53 years old and single. I make around $30,000 a year and have a disability with my hands that holds me back.
I am thinking of paying off the student loan with the inheritance money, because I will probably not get that high a return in the market, and because it would be really nice to be out of debt. I am currently in deferment with the loans because I can’t afford the $365 monthly payment. This adds about $100 of interest to the balance every month.
My plan is to immediately pay the loan down $14,000 out of the IRA, and to wait until the house sells and then pay the rest with the money from the sale of the house. I’ve been told that I will not have to pay taxes on the $30,000 because it is part of her estate. If that is the case, it is better that I wait until the house sells, rather than use the IRA money to pay off the whole loan.
This will get me pretty much debt free, and after taxes I will have $55,000 + left in the IRA. I don’t own a home and have no car payment. I might even be able to save money after that. I'd appreciate any feedback. I want to do what is best for my future, and I can’t afford to make the wrong decision at my age. --WL
A: You've put together a very sensible, well considered plan.
Before suggesting how you might tweak it to make it a little more tax-efficient, let's briefly explain to other readers the points that you already clearly understand.
The basic rule of thumb for figuring out whether to invest money or use it to pay off a debt is to compare the interest you pay on the debt with what you can earn in the investment. Paying off your student loans is risk-free. The only comparable investment would be an FDIC-insured product – and in today’s environment, that won’t return anything close to 7.75%! (These days, you won't make that by taking on the risk of stocks or bonds, either.)
You’re also right that you won’t owe taxes on the sale proceeds of your mother’s house. Capital assets like houses are inherited at their market value at the time of the previous owner’s death. (If a house is worth $100,000 when you inherit it, for example, you can sell it for $100,000 without incurring any tax.)
But you will owe income taxes on your withdrawals from the inherited IRA. And as I've explained in previous posts, you’re required to take minimum annual distributions from the account, beginning no later than December 31 of the year after your mother’s death. (The required distribution is based on your life expectancy. At 53, the Internal Revenue Service Single Life Expectancy actuarial table gives you 31.4 years. Your annual minimum distribution is the IRA’s balance at the end of the previous year divided by your life expectancy. Let’s say $75,000 divided by 31.4, which would be $2,388.53.)
It's a good idea to use the $30,000 from the house and $14,000 from the IRA to pay down your student loans, says Barry C. Picker, a Brooklyn NY tax accountant and IRA expert. But from a tax standpoint, it would be more efficient to take $14,000 from the IRA in monthly withdrawals than in one shot.
He suggests you make the $30,000 payment first, and then withdraw $365 a month from the IRA to pay whatever loan balance remains. (“And to the extent that you can afford, say $100 a month from your salary, you only have to pull $265 a month from the IRA,” he adds.)
1. Making monthly payments spreads the income tax burden: If you take $14,000 in a single withdrawal, you’ve increased your taxable income for that calendar year by $14,000. If you divide $14,000 into monthly $365 payments, it boosts your annual taxable income by only $4,368 for three calendar years.
2. Making monthly payments would cover your required minimum withdrawals for three years. With a single withdrawal, no matter how big, you only satisfy one year’s distribution requirement.
3. Making monthly payments is slightly better for your credit score. If you retire your loans with a single payment, you’ve reduced your outstanding debt. That’s good for your ‘total debt amount’, which accounts for 30% of your credit score. If you retire a debt in monthly payments, you improve your 'credit history', which accounts for 35% of your credit score.
That said, your plan is a good one even if you opt for the less tax-efficient -- but perhaps more emotionally satisfying -- approach and get rid of that debt as fast as possible. If that’s your choice, I certainly won’t fault you for it!
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
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