After John died, Judy lived rather frugally, as do most retirees. So, when she died she still had $200,000 in her IRA. She left 50% each to her two children, Jimmy and Jenny.
Jimmy is a married Radiologist making $500k a year. Jenny is a divorced gas station attendant making $35k a year and heavily in debt.
Jimmy has no cash flow needs so he rolls the $100,000 Judy left him into an inherited IRA. He still needs to take annual required minimum distributions. But while those distributions won’t be much initially because he is only 50 years old they will grow each year. Unfortunately for him, as long as he’s making the same income he’s going to lose 35%, or more, to federal income taxes.
Unlike Jimmy, Jenny is in desperate need of cash. Creditors are calling and she is late on rent. She takes a lump sum distribution of the entire $100,000 which put her gross income for the year at $135,000. Her total tax will be around $23,800 once she takes the distribution, which means she is going to lose nearly 25% of the amount she inherited! Ultimately, a third of John and Judy’s savings will be lost to taxes.
Tax-Free Inheritance or Taxable?
Regardless if you’re a high-income earner like Jimmy who doesn’t need the cash, or a low income earner like Jenny who desperately does, wouldn’t you rather receive the inheritance tax free so you could keep all of the proceeds?
If John and Judy had left their children Roth IRAs every single penny would have gone to them and none to the IRS. All that was required was for them to have done a bit of tax planning while they were alive.
Be advised, there is no getting around paying tax. Someone is going to pay some tax. But with proper planning, John and Judy may have been able to pay tax at 10% which would have allowed the kids to avoid avoid losing a third of their inheritance to tax. The question is what should you be doing now to minimize taxes to enhance your family’s wealth while sustaining your own income?
