By: Herbert Diamant
IRAs are no longer tax-efficient, multigenerational, wealth creators. Back in 1981, IRAs became a terrific way to promote retirement savings for individuals. Americans began making tax deductible contributions while working, with distributions that would be taxable in retirement years. A key provision was that beneficiaries, including our children, could inherit our IRAs and have these assets support them during their lifetimes.
As IRAs became larger, the ability to have the next generation inherit and use these assets for their retirement became an essential part of our long-term planning. After the owner of an IRA died, when children were named as beneficiaries, their children inherited these IRA assets. For the rest of their lives, the child would receive their required minimum distributions. In essence, the original depositor parent not only used their IRA to provide for their retirement years, but they also gave their child part of their inheritance within the structure of an IRA. Since all IRA distributions are taxable, most children left their inherited IRA intact, allowing it to provide for the child’s retirement years. During a 39 year period, everyone made IRA contributions with the understanding that children could use the inherited IRA over their lifetime.
Then, in 2020, in what seemed to be a political feud between President Trump and a Senator with a large IRA, politicians abruptly changed every IRA by terminating the ability to have a child designated beneficiary distribute an inherited IRA over their lifetime. They changed the rules just after a large demographic of Baby Boomers had made substantial contributions to their IRAs.
Then in 2022, President Biden codified this policy with accelerated taxation of IRAs. Now, every IRA inherited by someone other than a spouse must distribute all these assets annually within 10 years of the owner’s death. This forced dissolution of all these inherited IRAs means the government will now collect more income taxes in a shorter time frame from the beneficiaries.
Although great news for covering the politicians spending needs, this is exactly the wrong strategy for the United States. The concept of passing inherited retirement accounts to others for their long-term retirement provided each beneficiary with a nest egg for their retirement. Much of this additional financial independence for beneficiaries is now lost to taxes.
Politicians again missed the big picture as they changed the landscape without understanding the long-term consequences. These inherited IRAs provided financial independence that would reduce reliance on the Social Security system. The reality is that the Social Security trust funds will be depleted in 2041, since incoming funds have not been sufficient to cover payouts. As things currently stand, Social Security may not be viable for the next generations of retirees. Having IRAs stretch over to the next generation was a solution to this problem.
The impact on everyone’s existing IRAs is large. For our younger clients, we will need to create another form of retirement account for our clients. We call this having a “nest egg” account, which will have greater importance for individuals. We will fund these accounts with after-tax dollars.
For existing IRAs, knowing that this legislative change forces children to liquidate these inherited assets in ten years, there is little reason to make further contributions to retirement accounts. A spend now mentality starts to make sense. Deliberately spending down retirement accounts is a strange concept to us, but this is the impact of this absurd legislative change.
Moreover, once children inherit an IRA and understand its taxation, they recognize that this IRA is not really for their retirement. Some take a lump sum to spend on things, and others spend it over ten years. The tax problem is that this inheritance gives the children a mandated additional taxable income at the time in their lives when they are reaching peak earnings. Then the IRA simply triggers more taxes paid at their top marginal tax brackets.
The problem is much worse when a child receives a substantial inherited IRA. If they inherit a $1 million IRA, they now must receive a taxable distribution of $100,000 a year for a decade. This changes behavior. Once these payments begin, they believe they no longer need to work, or at least not work as hard anymore. Then, at the last payment, the IRA is fully spent, with no inherited retirement account to support them anymore. Grown children will have experienced a decade of not working, and will have great difficulty returning to the workforce to provide for their retirement needs. This situation was never the intent of the parents when they were building their IRAs for generational wealth.
This retirement disaster was created by politicians of both political parties, who were elected to serve the very people they now are harming. Until this is corrected, we must adjust our investment strategies to reduce the generational impact of this poorly thought-out legislation.
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