Years ago, I was referred to a young couple – Bill and Mary - who
wanted some help with their money. They
were both 30, had good jobs, and were looking forward to their life
together. In all respects, they looked
like a typical young couple.
Some months prior, the Bill’s mother had passed away and left him an
IRA worth $40,000. One of the reasons
they wanted to sit down with me was to understand their options with this
account.
When it comes to inherited IRAs, there are specific IRS rules that must
be followed. Simplistically, the key
question is how fast you want to take the money out. As a non-spouse beneficiary, Bill could not
combine the inherited IRA with his own.
As the young couple was starting out, they wanted to do what many
couples in their position want to do – buy a house!
Before I had a chance to speak with them, they did what most
people would do in this case – they took the money out and put it as a down
payment on their new home.
Let’s take a look at some numbers here:
Withdraw the $40,000 – good!
Pay income taxes as well as a 10% penalty as they are both under 59 ½ -
$16,120 – boo!
Net amount is just under $24,000.
As an alternative, Bill could have taken out the money slowly based on
IRS life expectancy tables. The IRS
allows beneficiaries to do this – though taxes would be due, there would not be
a penalty and the remaining balance would continue to grow.
Assuming a hypothetical 5% return, what would have Bill gained by his
retirement age of 67?
Over the years, Bill would have taken out almost $54,000 in
distributions after tax.
PLUS the inherited IRA would still have just under $78,000 left in the
account.
Plus the taxes and penalties they paid by withdrawing the account -
$16,000!
Total? Almost $149,000!
(Bill and Mary threw away $125,000!)
What if we were conservative and used a hypothetical 1% return? Well, it would still be about $57,000. Bill would have received $23k in after tax
income. The account will still have $18k
left. And of course, the $16k Bill and
Mary paid in taxes in the beginning.
This situation reminds me of an old Sprint commercial. There were several of this type and they
still make me laugh.
Bill and Mary used that money as a down payment and I’m sure their home
is very nice. They made their decision,
and I certainly wouldn't judge them for doing so.
They didn't understand IRS rules regarding this situation and it cost
them. Bill was an engineer and I can’t
remember what Mary did professionally.
But neither were tax or IRA experts!
This example is one way people spend money unknowingly, without thinking
it is really “spending”.
Beneficiary designations and planning isn't just about picking some
names. It also is about what options you
want to leave to your beneficiaries.
This was a fairly simplistic scenario, but if siblings were involved, or
the other parent (Bill’s father) was still alive, things get more complicated
in a hurry.
When was the last time you reviewed your beneficiaries?
