It would be hard to find a podcast-hosting duo more totally invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they put "Answers" in the show's name, for goodness' sake! And this week, they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners. But because three heads are better than two, for this episode, they've enlisted the help of Sean Gates, a financial planner with Motley Fool Wealth Management.
In this segment, listener Kevin is trying to decide what to do with IRA he inherited: Either withdraw more money now and have it taxed as ordinary income, then reinvest it and let its growth be taxed as long-term capital gains, or leave as much as he can in the account to grow tax-deferred? It's a complicated and very personal question to answer, but the trio has some tips.
Sean Gates is an employee of Motley Fool Wealth Management, a separate, sister company of The Motley Fool, LLC. The views of Sean Gates and Motley Fool Wealth Management are not the views of The Motley Fool, LLC and should not be taken as such.
A full transcript follows the video.
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This video was recorded on June 26, 2018.
Alison Southwick: Next question comes from Kevin from Phoenix. "I have an inherited IRA from a non-spouse that I've elected to take required minimum distributions from. I can remove any amount of money from the account, but it will be fully taxed according to my income level. As long as I'm taking the required minimum distributions each year, the rest will grow, tax-deferred. If I am committed to a Foolish philosophy of investing that has a very long time horizon, would it be wise to remove larger amounts of money from the inherited IRA now and let it be taxed as ordinary income so that the future growth could be taxed as long-term capital gains? Otherwise, if it's kept in the IRA, then all the gains will eventually be taxed as ordinary income."
Sean Gates: This is a great question, and I don't have a good answer -- no, just kidding. Part of the reason I like this question is because it delves right into the heart of pretty much how I help people, the vast majority. This is the No. 1 way that I help people the most. The best way to think about it is income recognition. You have all of this wealth that you've spend all of your mental energy thinking of and accumulating. Then, once you have to flip it over to actually distributing it to yourself, you don't know which account to pull it from, when. This goes to the heart of it. A couple of things to consider, because I don't think I can answer it outright on this podcast --
Southwick: Because it'd be too specific and personal?
Gates: Yeah, maybe too specific, but I'd probably arm you with enough information to hurt yourself and I don't -- well, actually, I'm OK with that. Talking to Al. In this case, the things to consider are, you haven't really outlined what your tax rates are. If you make $700,000, in the 35% tax bracket, then it almost certainly does not make sense to recognize that income now. I think you're missing the forest for the trees. Tax deferral is an amazing benefit in and of itself, and at your high tax bracket, being able to defer that in perpetuity is the best thing you can do.
If you're in a lower tax bracket, much smarter to do this. Then it becomes a game. What if you're in the 20% tax bracket? Then you need to think about timeline. If you're 20 -- I don't think he said how old he was, either -- then maybe, because maybe now you know you have a long enough timeline, and you can start to almost project into the future. If you pull it out of your IRA, No. 1, you won't have that account recognize you with required minimum distributions when you're older, and that's a benefit long-term; No. 2, if you pull it into a taxable account, the other thing to consider is that if you have goals to leave those moneys to heirs, then that taxable account would get a step up in basis for your heirs when you die, which the IRA does not. So, they would owe income taxes on the income from your IRA that you haven't reduced by pulling money out sooner.
Just some things to think about. There are a lot more in there. Another good thing to think about is, if you're working now and you know for the next ten years that's your plan, but in year five, you take an unpaid sabbatical and you don't have income in that year, that might be the year where you're like, "OK, I'm going to do this, I'm going to take a large chunk out of my IRA." It's just a game of mapping out future probabilities and recognizing this income in the most optimal time period.
Robert Brokamp: And obviously, while the money is in the IRA, you're not paying taxes on interest, on dividends, on any capital gains. Once you take that out, you'll pay ordinary income on distribution, then, even if you hold onto a stock for 20 years, if it pays a dividend, you'll pay taxes. If want to pare it back a little bit or rebalance, you'll pay taxes. There's a lot of benefit to keeping money in a traditional IRA, a regular IRA.
I'll just point out, this is something that a lot of people aren't aware of -- if you inherit an IRA from someone who wasn't your spouse, you do have to take out a required minimum distribution every year.
Gates: Yes, it's a super important point. If you're a day trader, this isn't going to make sense. If you follow the Foolish investing philosophy, it might make more sense. Yeah, totally.
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