Lynn Brenner's Family Finance

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

Retirement Plan Rules Say I Must Withdraw My Account at 70 and a half. Will I Have to Pay Taxes on It?

Q: I'm a 68 year-old with zero tax deductions who is still working. I'm maxing out on my contributions to my Thrift Savings Plan retirement account, plus doing my over 55 catch-up contribution to reduce my taxable income. I'm considering withdrawing about $60,000 from my account to pay off my mortgage. I owe about $26,000 on the house at 6.75%. I'd convert the rest into my Roth IRA. I do have funds to pay the taxes on this withdrawal.

I have two questions. First, what's the most I could withdraw without going into a higher tax bracket? Second, I've heard that if you take a withdrawal while still working, when you do retire and turn 70 and a half, you must withdraw the whole account. That would mean a big tax bill. If this is true, is there a way around it? --RC, via email

 

A: You should take the first question to your tax accountant. Even a tax professional can't tell you how much you can withdraw without being bumped into a higher tax bracket without more information about your situation.

But you don't have to worry about the second question. You won't be hit with a big tax bill at 70 and a half.

Let's make things clear to other readers by explaining that the Thrift Savings Plan (TSP) is the defined contribution plan for federal government employees. In many respects, it resembles a 401(k) plan -- but not in all respects.

For example, 401(k) plans only permit pre-retirement withdrawals under very specific conditions of financial hardship. By contrast, the TSP allows its participants to do a one-time pre-retirement transfer of money to an IRA after turning 59 and a half.

This is called an 'in-service age-based withdrawal'. That's what will let you withdraw $60,000 from your account. (To comply with the rule, you'll probably have to transfer the entire $60,000 to the Roth IRA, and then use $26,000 to pay off the mortgage.)

The same TSP rule that permits this type of pre-retirement withdrawal says that if you use it, you must take the rest of your money when you retire.

But that doesn't mean you'll have to pay taxes on the entire amount. All you need to do to preserve its tax-deferred status when you retire is transfer it from the TSP into a traditional IRA.

By April 1 of the year after you turn 70 and a half, you must start taking minimum annual withdrawals from your tax-deferred retirement accounts. (This is true whether your money is in the TSP, a 401(k), or a traditional IRA). But only the amount you withdraw is taxable. The balance remains tax-deferred.

You're never required to take withdrawals from your Roth IRA; but any withdrawals you do take are tax-free after you're 59 and a half and have owned the account for five years. The five year clock starts on January 1 of the year you open your first Roth IRA, and that date applies to all your subsequent Roth IRA contributions to that account, as well as to Roth IRA accounts you open later. (As far as the Internal Revenue Service is concerned, you have only one Roth IRA, no matter how many accounts it's divided in.)

Your $60,000 withdrawal will be subject to income taxes since you're not going to transfer it into a traditional IRA. Even so, using this money to pay off the mortgage can make financial sense:

You say you have zero tax deductions. In other words, you aren't deducting the 6.75% interest you're paying on the mortgage. (Your mortgage is almost paid off, which means the interest portion of your payment is very small. The interest is probably less than your standard income tax deduction, says Barry C. Picker, a Brooklyn NY tax accountant.)

Since you aren't getting a deduction for that interest, using $26,000 to pay off the mortgage is like investing the money at a risk-free 6.75%. You can't beat that these days!

One suggestion: Convert the withdrawal into a new Roth IRA. Don't put this money in an existing Roth IRA. Here's why:

If you do a Roth IRA conversion in 2010, you have until October 15 2011 to change your mind and move some or all of the converted amount back into the tax-deferred retirement account it came from. (This is called 'recharacterizing' the conversion.)  It's much, much simpler to do this if you haven't commingled the converted money with an existing Roth IRA.

After the recharacterization deadline has passed, you can always consolidate your Roth IRAs if you wish. Even if you don't, the five year clock that started with your first Roth IRA will apply to the new one too.

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

 

 

Can my creditors seize an IRA I inherited from my mother?

Q: I have an inherited IRA from my mother, who passed away several years ago. I also have credit card debt that I cannot pay due to being unemployed. I use the IRA for total support. Can the credit card company invade my IRA if they get a judgment against me? -- AB New York City

 

A: In some states the answer is no; in others it's yes. But the answer for New York residents is still unclear, says Seymour Goldberg, a Melville New York estate lawyer.

The extent to which IRAs are protected from creditors depends on state law.

There are nine states that specifically shield inherited IRAs from creditors. 

In several other states, however, courts have held that inherited IRAs don’t qualify for protection from the beneficiary’s creditors. The question hasn't yet been argued in a New York court, Goldberg says.

New York law protects an IRA from its owner's creditors, but it says nothing about inherited IRAs.

There's a difference.

It’s natural for you to refer to this inherited IRA as yours. But technically, it isn’t yours. It’s still your late mother’s IRA. You are merely the beneficiary, says Ed Slott, a Rockville Centre NY tax accountant and IRA expert.

One difference, for example, is that if it were your own IRA, you could name a beneficiary. Since it's an inherited IRA, you cannot.

When you inherit a spouse’s IRA, you can make it your own by transferring it into a new IRA in your own name.

But every other beneficiary must keep an inherited IRA in the original owner's name to retain its tax-deferred status. If Fred Smith inherited his mother Mary Smith's IRA when she died on January 1, 2006, the account should be titled: `Mary Smith IRA (deceased 1/1/06) for the benefit of Fred Smith’.

 

DO WE HAVE TO PAY OUR LATE FATHER's Credit Card Debts?

Q: My father passed away last year. My mother, who was on Medicaid, passed away in January. My father had credit cards which only he signed for. We've been getting letters from the credit card companies, saying that they'll settle for 80% of the bill. What should we do? --SD, via email

                                                                                                                                   

A: Don't pay anything unless they can show that your mother co-signed for the credit cards.

The fact that your late father's credit card issuers have offered to settle for partial payment doesn't mean they're actually entitled to anything, says Stephen J. Silverberg, an East Meadow New York estate lawyer.

Bereaved survivors very often assume that they are legally obligated to pay the debts of  their deceased relative -- a mistaken assumption that is often shamelessly encouraged by creditors, as your experience shows.

In fact, however, any legitimate debts incurred by your late mother must be paid by her estate – the assets she left when she died. Although that might result in a smaller legacy for you and your siblings, you have no legal obligation to dig into your own pockets to pay her debts.

(And as I've explained in earlier posts, creditors don't get a crack at  everything a decedent leaves.  They cannot  recover their money from assets with named beneficiaries, like Individual Retirement Accounts or 401(k) accounts, or from life insurance policies, for example,  or from assets that were owned jointly with someone else.  Accounts with named beneficiaries go to those beneficiaries, and jointly-owned assets go to the surviving joint owners.)

But if your mother didn't co-sign for your father’s credit cards, her estate doesn't owe these card issuers anything at all.

It is true that by state law, spouses are legally responsible to pay for each other's ‘necessities’.  That means  that the extent that your father's credit card debts were for food, clothing, shelter or medical bills, the card issuers can argue that your mother's estate is liable for them.

"If so,  let them make that argument in Surrogate's Court," says Silverberg. "I doubt they'll show up."