By: John Kolb

Everyone knows that you can sometimes have too much of a good thing. Put too much air in your tires and you increase the risk of a blowout. Ride Space Mountain too many times and you’ll probably get sick. Drink too much water before bed and…well, you know.

But what most people don’t know is that you can also put too much money in your Traditional IRA or pre-tax retirement plan¹.

A Traditional IRA is one of the single most powerful ways to save for retirement. That’s why many people contribute as much to one as they possibly can. But while a large IRA is a blessing for retirees, it can be a major burden for families. That’s because large IRAs come with a major potential tax trap for heirs and beneficiaries that all retirees should factor into their own retirement/estate planning.

Understanding the 10-Year Inheritance Rule

It all started in 2020 after Congress passed the SECURE Act. When this law went into effect, it created a new rule where beneficiaries who inherit an IRA must withdraw the full amount within ten years.

Now, on the surface, that might not sound like a big deal. And for some, it’s not! But for those who inherit a large IRA, this means withdrawing a lot of money in a relatively short amount of time. Money that the IRS classifies as income.

What happens when your income goes up significantly?

You get bumped into a higher tax bracket.

A higher tax bracket isn’t the end of the world, of course, but it can come with all sorts of unwanted side effects. It can mean losing eligibility for various deductions and tax credits. It can indirectly lead to higher IRMAA surcharges for Medicare due to having a higher adjusted income. Furthermore, many people inherit IRAs when they are in their fifties and sixties, a time when their personal, pre-inheritance tax burden may already be on its way up. Inheriting a large IRA, then, just compounds the effects.

And that’s just the SECURE Act. To complicate matters even further, we have to consider the sequel: SECURE ACT 2.0.

SECURE Act 2.0 went into effect in late 2022. Among other things, it raised the age at which retirees must begin taking required minimum distributions (RMDs) from their traditional IRA from 72 to 73. (In 2035, the age will jump again to 75.) This means the tax bill on an inherited IRA may get even larger in the future, because the original owner may not have taken out as much beforehand.

Now, there’s no official definition for what constitutes a “large” IRA. What might be a gargantuan sum of money to one person may be a drop in the bucket to another. This situation is also affected by how many beneficiaries there are. Obviously, an IRA divided between twelve people means a much lower tax burden than the same IRA shared between only two. Still, as a rule of thumb, let’s label any IRA that contains around $2-5 million as a good starting point. Inheriting an IRA in that range means taking annual distributions of $200-$500k per year to comply with the SECURE Act’s 10- year rule. That’s practically guaranteed to bump your beneficiaries into the next tax bracket…and maybe even higher.

So, that’s the problem. What’s the solution?

Fortunately, there are several strategies to consider. Each can help you reduce the future tax burden on your beneficiaries without incurring a large tax burden for yourself.

Strategy #1: Use QCDs before RMD age

First up, we have Qualified Charitable Distributions, or QCDs.

A QCD allows individuals aged 70½ or older to make a tax-free donation directly from their IRA to the charity of their choice. (This can also be used when you are 73 in place of the RMDs you must take each year.) QCDs are handy because they reduce the overall taxable amount of your IRA for when you bequeath it to others down the road.

This strategy is perfect for those who are already involved in charitable giving, which is why many of our clients use it here at Hudock Capital. For example, I recently helped a retired client of mine who didn’t need the cash from his IRA before taking RMDs. He was already giving a regular amount to charity, so we simply switched from making direct contributions out of his checking account to tax-free distributions from his IRA instead. Now, he can reduce his overall IRA balance, while continuing to build a legacy, and lessen the future tax burden on his heirs. Win, win, win!

Strategy #2: Name a charity as one of your IRA beneficiaries instead of in your will

This is a clever approach, because charities are exempt from paying taxes on inherited IRAs. Naming one as your beneficiary maximizes the value they receive while simultaneously lowering the tax burden for your other beneficiaries, who no longer need to withdraw as much over ten years.

(As a side note, if you are planning on leaving any bequests to charities in your will, it can be smarter to direct the funds to come out of your IRA instead of your overall estate. Again, charities don’t pay taxes on inherited IRAs, so from a philanthropic standpoint, this is much more efficient than gifting directly from your will.)

Strategy #3: Make a direct gift out of your IRA to children and grandchildren

This is probably the simplest approach. Here, you simply gift your Required Minimum Distributions to your beneficiaries ahead of time rather than giving them the entire IRA to inherit later. While there’s nothing “tax free” about this approach, it does spread the tax burden out over a longer period of time, which can be the difference between moving into a higher tax bracket or not. This can also be a good option for beneficiaries who need the money now more than they will in the future.

Those who live in states with an inheritance tax — like Pennsylvania, Kentucky, Maryland, Nebraska, and New Jersey— should also seriously consider this option².

Strategy #4: Roth conversions

This is a strategy that nearly everyone should consider, even if you aren’t dealing the “large IRA” problem. For those who do have large IRAs, the idea is to convert a portion of your traditional IRA to a Roth between retirement and when you need to start taking RMDs. By doing this, you are moving a portion of your pre-tax savings and then paying the tax on that amount. After that, the funds can continue to grow, and so long as the Roth has been open for at least five years, your beneficiaries can inherit it without having to pay any taxes at all. (All funds must still be withdrawn within ten years of inheritance, however but will continue to grow tax-free until then.)

Now, there are a few things to be aware of with this strategy. First is that a Roth conversion can potentially bump you into a higher tax bracket. It can also lead to higher Medicare surcharges. So, you have to do the math carefully here. That’s why whenever we help clients execute a Roth conversion, we highly recommend coordinating with their CPA first to make sure there are no unintended consequences.

(Another side note: All pre-retirees should explore making contributions to a Roth IRA, Roth 401(k), or using back-door-Roth contributions (For those above income limits) as early as possible. You never want to get to get to retirement and realize that all of your savings are pre-tax. Instead, consider a mix of pre-tax, post-tax, and taxable investment accounts as a way to save for retirement while also minimizing both present and future taxes.)

Whether you find yourself overwatering your plants, staying out in the sun too long, or building up a very large balance in your Traditional IRA, always remember that you can have too much of a good thing. If you have a large IRA that you plan to pass on to your children and grandchildren someday, it’s important to have a strategy in place first. So, if you are unsure whether you are doing everything you can, planning-wise, give us a call. We can evaluate your situation, review your options, and help you select the best strategy for you and your family.

Have a great month!

— John Kolb

¹ Pre-tax retirement plans include 401(k), 403(b), or other retirement plans that contributions are made pre-tax which reduce current income but are taxed as ordinary income when distributions are made.

² This list is not an inclusive list for all states that have estate or inheritance tax. Please consult with a tax professional regarding your specific state’s estate or inheritance tax.