Lynn Brenner's Family Finance

'Sweet Spot': The Key 11 Years of Retirement Planning

If you're nearing age 59 or you haven't yet reached age 70, listen up.

You're standing in a window of opportunity -- the 'sweet spot' of retirement planning. Now's the time to take steps to protect your future retirement income from the ravages of annual taxes and market volatility.  For more, see my recent Reuters article "Six Ways to Maximize Retirement 'Sweet Spot' Years".

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

A Smart Move: Using Inherited IRA to Pay Student Loans

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.)

Here’s why:

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 [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Tapping an Inherited IRA: Don't Shortchange Yourself!

Q: I have an Inherited IRA. I've chosen to take distributions from the account over five years. I'm in the second year now. I have two questions. 

First, is the distribution amount determined by the IRA's value in the first year, or does the amount change over the five years due to losses and gains in the account?

Second, I'd like to skip this year's distribution to avoid being pushed into a higher tax bracket. Is it possible to skip this year and divide the remaining distributions among the three years I have left? --PS via email

 

A: You have more freedom than you realize. 

First, it sounds as if you still have the option to take minimum annual distributions based on your life expectancy. If so, you should grab it. It's a better deal than having to empty the account within five years. 

Second, even if you stick with the five-year rule, it doesn't require annual distributions. It just says you must empty the Inherited IRA by the end of Year Five. If you want, you can skip years one through four and withdraw the entire balance at the end of year five.

"IRA custodians don't usually ask for an affirmative election of the five-year rule," says Barry C. Picker, a Brooklyn NY CPA and financial planner. In other words, you probably aren't committed to emptying the account in five years and still could switch to withdrawals based on your life expectancy.

Before explaining why that's preferable, let's quickly recap the rules. What you can and can't do with an Inherited IRA depends partly on whether you were married to the original owner. We'll keep it simple and say you inherited an IRA from your uncle Joe. 

--If you're the named IRA beneficiary, and Joe was under 70 1/2 when he died, you can a) take yearly distributions over your lifetime; or b) empty the IRA within five years. It's hard to imagine a situation in which b) would be a better choice, says Picker.

--If you're the named IRA beneficiary and Joe was over 70 1/2, he was already taking required distributions from his IRA when he died. In that case, you can a) take annual distributions based on your life expectancy; or b) take annual distributions based on Joe's remaining life expectancy had he lived. If Joe was 76, for example, he had a 22 year life expectancy. "But in this situation, you don't have the five-year option," says Picker.

--If you weren't the named IRA beneficiary, you have fewer choices. For example, perhaps Joe made you his heir in his will, but neglected to fill out an IRA beneficiary form. In that case, says Picker, the IRA beneficiary is actually Joe's estate. You inherited the estate, so you get the IRA -- but you don't get a beneficiary's option to stretch distributions over your own life expectancy. If Joe was over 70 1/2 when he died, you can take annual distributions based on his remaining life expectancy. But if Joe was younger, you must empty the IRA within five years. 

Okay -- so let's assume Joe died in 2010. You inherited his $100,000 IRA as the named beneficiary, which gives you several distribution choices. You picked the five-year option. You took a $20,000 distribution in 2010, assuming that it was required. But actually, the five-year rule just says you must empty the IRA by December 31, 2015 -- the end of the year containing the fifth anniversary of Joe's death.

By contrast, with annual distributions based on your life expectancy, you must take the first distribution by December 31 of the year after Joe's death -- i.e. December 31, 2011.

If you're 48 years old, you have a 36 year life expectancy. Each annual distribution is based on the IRA's value at the end of the prior year. If there was $80,000 in the IRA on Dec. 31 2010, your 2011 required distribution is $80,000 divided by 36 -- $2,222.

Lifetime distributions are a better choice because they minimize the amount you must take out every year. There's less of a tax bite, and less chance that a distribution will push you into a higher bracket. And as I explained in this earlier post, your inheritance has a chance to become much bigger because the IRA balance can grow tax-deferred basis much longer. And there's no downside: You're always free to take a bigger withdrawal if you need the money.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved.

 

Is My Inherited IRA Subject to EstateTax?

Q: My mom passed away in November 2010. She was a New York resident and left an IRA with two beneficiaries, myself and my sister. Is that IRA considered an asset for the purposes of New York State estate taxes? The bank has already completed transfer of the IRA distributions. I’ve rolled my portion to a new IRA to avoid tax liability, and my sister took her portion in cash. I live in another state and I’ve been advised that this IRA wouldn’t be considered a taxable asset if mom had lived here. But I need to know if it is in New York. –DM

 

A: No matter what state you live in, your estate is the value of everything you own at the time of your death -- and that means everything, from your tax-deferred retirement accounts to the loose change on your bedside table. But not all states have an estate tax; and even the ones that do have an estate tax don't tax every estate.

New York taxes estates whose value is greater than $1 million. Let's say your mother’s total estate – including her IRA – was worth $1.2 million. In that case,  a New York estate tax is due on the $200,000 excess. If her estate was worth less than $1 million, there's no New York estate tax. (In case you're wondering, in 2010 there was no federal estate tax. In 2011 and 2012, federal estate tax appies only to estates worth more than $5 million.)

Don’t confuse estate taxes with income taxes. These are two entirely different sets of taxes, with different rules, tax rates, and exemptions!

Regardless of whether your mother’s estate was taxable, you and your sister will owe income taxes on the money you take out of her IRA. If the IRA is worth $200,000, for example, and you take a $10,000 distribution, that $10,000 is added to your taxable income for the year.

Your sister took her portion in cash. If she took it in 2011, she’ll owe income taxes on the amount of her cash distribution in April 2012.

You say you transferred your share into a new IRA to avoid tax liability. As I explained in an earlier post, that new IRA must still be titled in your mother’s name to preserve its tax-deferred status. Your name can be on the account too, but as its beneficiary, not its owner.

If you’ve done this transfer correctly, you’ll only owe income taxes on your annual IRA distributions. (You must take a minimum yearly distribution from the IRA based on your life expectancy.)  But the balance of the account will continue to grow tax-deferred.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved