When my father passed away, I was left with $200,000 in an IRA Beneficiary Distribution Account (BDA). I have 10 years to withdraw this money. I currently have the federal tax rate of 35% and plan to earn a similar annual income over the next 10 years. If I withdraw the money all at once my federal tax rate wouldn’t change, but neither would it if I withdrew it over a 10 year period. Is there a benefit to leaving this money in the IRA rather than withdrawing it now, paying the taxes, and then using it to invest in other financial instruments?
–Brad
At first glance it might seem like the answer is to withdraw everything now. The logic is that it would be better to allow overall growth to occur in an environment where the long-term capital gains tax rate applied instead of the normal income tax. This is often the case if you anticipate a change in your marginal tax rate. I don’t think this applies to your case as you expect to be in the 35% tax bracket going forward.
On the other hand, if you invest the money in the IRA, you can reduce the tax burden and potentially have more money left after ten years. But like many things in financial planning, the answer to your question may depend on whether tax laws change in the future. (And if you need more help solving questions like this, consider working with a financial advisor.)
Evaluate your options
To evaluate the two approaches, we want to compare the after-tax value of the $200,000 at the end of 10 years in both scenarios. We can achieve this by comparing the extreme goals: withdrawing the entire amount now or withdrawing the entire amount at the end of 10 years. If one of the outcomes is better – and we hold the same assumptions (returns, taxes) constant over the 10-year periods – varying both options would produce a similar result, just to a lesser extent.
Depending on whether your father has already started taking required minimum distributions (RMDs), you may have different withdrawal options available. If so, keep in mind that you will likely also be subject to an annual RMD requirement unless you meet one of the exceptions.
So let’s get started.
Measuring results
First, we need to understand how much you would have to invest in each scenario. If you withdraw $200,000 and 35% of it goes toward taxes, that leaves you with $130,000 to reinvest. Of course, if you just leave it in the inherited IRA, all $200,000 will remain invested.
Next, we need to forecast how much money is expected to grow over the next 10 years. We can choose any annual return as long as we use the same return for each. I chose 10% simply because it is a round number.
In the first scenario, $130,000 would grow to about $337,000 in 10 years, assuming a 10% annual return. On the other hand, if you leave the $200,000 in the IRA and experience 10% annual growth, that leaves you with about $519,000 before taxes.
Finally, we need to calculate the after-tax value of the money in each scenario.
Since you would have already paid taxes on the original $200,000 withdrawal in the first scenario, all we need to do is calculate the capital gains tax you would pay on the investment earnings. If we simplify and generously assume that the $207,000 gain from the first scenario is treated entirely as a long-term capital gain, you would owe about $41,000 in taxes if you withdraw the money in 10 years. That would give you about $296,000, including the principal amount of $130,000. I have used the long-term capital rate of 20% here, although some of these may only be subject to the 15% rate (even if all were affected, the result would not change.)
In the second scenario, a withdrawal of $519,000 at the end of 10 years would mean paying 35% income tax on the entire balance, leaving you with $337,000 – $40,000 more than in scenario 1.
From a purely tax perspective, there might be a reason to leave it in the IRA for 10 years. (And if you need help crunching the numbers to answer similar questions, consider contacting a financial advisor.)
Leave it in the IRA?
Not necessarily. You always want to think about how a particular approach fits into your overall financial plan. You may also want to consider possible variations on the assumptions we made in the scenarios above. Examples of such variations could be:
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Your returns may not be the same in each scenario. There will likely be some tax burden on money invested outside of the IRA. Of course, there is also the possibility of making losses.
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Tax rates could increase in the future. Maybe you decide to leave the money in the IRA, only to find out that in ten years you’ll be in a new 70% tax bracket. You would also need to consider how capital gains tax might change.
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Your tax situation could change. You might change jobs, face a layoff, or have some other experience that causes your income to decrease and your tax rate to change.
This is not about introducing unnecessary complexity. Instead, I point out that circumstances can change regardless of the numbers in the table. You need to decide how you want to deal with these prospects. (And if you need a financial advisor to help you with this, this tool can help you find a match.)
Bottom line
Tax-advantaged accounts like an IRA Beneficiary Distribution account offer some clear benefits for long-term savings. The best way to use them may vary and depend on individual circumstances. This includes current and future tax rates, but also preferences and assumptions about your future income needs.
Tips for Finding a Financial Advisor
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Brandon Renfro, CFP®, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question you would like answered? Email [email protected] and your question may be answered in a future column.
Please note that Brandon is not a participant in the SmartAdvisor Match platform and has received compensation for this article. Questions may be edited for clarity or length.
Photo credit: ©iStock.com/Dean Mitchell, ©iStock.com/Dean Mitchell
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