Distributing an Inherited IRA as an early retiree

[theupperwestmike]

Hi,

This year my spouse received an Inherited IRA from a parent of $250k. We are a family of two and use ACA and get health insurance subsidies based on our roughly $45k in total income in early retirement. With the Inherited IRA 10-Year Rule, we will need to take distributions of the full $250k by 2032. (We're dollar cost averaging it into broad market funds so would expect it to grow over those 10 years, too.) We still won't be on Medicare by that time so expect to still be using the ACA for healthcare.

Can you give us pointers on what factors to think about when deciding to take distributions? I have a feeling that neither adding $25k of income each year for 10 years nor taking the full tax hit of $250k in a single year are ideal. (But there's value in simplicity!)

What should we consider? What would you recommend?

Mike

[gocurrycracker]

Hi Mike

Sorry for your loss

I wrote a post about the tradeoffs on an inherited IRA awhile back
https://www.gocurrycracker.com/the-secure-act-compression-of-the-stretch-ira/

The balancing act between withdrawing the IRA funds in 1 year or 10 years is going to be guided by the marginal tax rates you pay, including ACA subsidies.


Background:

The Inflation Reduction Act extended the enhanced ACA subsidies (up to 600% FPL) through 2025. After that subsidies halt at 400% FPL unless new legislation is passed.
There is a chart of ACA "tax rates" in this post.
https://www.gocurrycracker.com/american-rescue-plan-act-of-2021/

This means through 2025 we have a wide 8.5% ACA tax bracket, which could be taken advantage of from 400% to 600% FPL (if beneficial)

For household size = 2
$45k = 258% FPL
$69,680 = 400% FPL
$104,520 = 600% FPL

Numbers from
https://www.gocurrycracker.com/aca-premium-calculator/

Similarly we have Federal income tax
0% - $25900
10% - $46450
12% - $109,450
22% - $204,050
24% - above $204k

Numbers from
https://www.gocurrycracker.com/federal-income-tax-calculator/


Tradeoffs:

You have income of $45k, ~260% FPL. At most you pay ~$2k/year for an ACA silver plan ($1944)

You are nearly at the top of the 10% federal tax bracket, plus whatever you pay in State taxes (IL(?), flat 4.95%)
You pay 0% tax on qualified dividends at the federal level, so total tax is probably 0

State tax
With a flat state tax you pay the same rate whether you withdraw $1 or $250k, so I will ignore this.
If in a state like California with a big progressive tax system, this would need to be factored in.


Now, let's add inherited IRA withdrawals

Starting with the extreme
$250k withdrawal

Income now $295k
Will pay full fare on ACA insurance - let's swag $8.8k (fill in your own number if you have it - this is the max allowed at 600% FPL and assumes no subsidy cliff.
($8800 actually seems high for 2 people, we would pay $12k for 4.)
In 24% federal bracket, total federal tax assuming all ordinary income - ~$50,5k
State tax - $x
Effective tax rate on IRA withdrawal = ~$7k (extra ACA) + $50.5k (extra Federal) / $250k = 23%


Top of 600% FPL bracket
Income: $45k
IRA withdrawal: $59,520 (~5 years to deplete IRA +/-, but only guaranteed 600% FPL for 3 more years)
ACA - $8.8k
IRS - ~$6.6k
Effective tax rate on IRA withdrawal = ~$7k (extra ACA) + $6.6k (extra Federal) / $59,520 = 22.8%


By extending the withdrawals out over a longer period (5 years) we save 0.2% in tax
Making a very large withdrawal above the ACA subsidy cliff means a large portion of the withdrawal is not "ACA taxed" at all, so loss of ACA subsidies only contributes 2.8% tax rate

We can continue downward


Top of 400% bracket
Income: $45k
IRA withdrawal: ~$25k
ACA - ~6k
IRS - $2.5k
marginal rate: $4k (extra ACA) + 2.5k (extra Federal) / $25000 = ~$26%

This actually costs more because most of the withdrawal is ACA taxed at the highest point in the ACA tax curve (~15% vs 8.5%)




Some other things to consider:
Presently at $45k income you MIGHT get some CSR subsidies (they stop at 250% FPL and you may be over or under depending on which side of "roughly $45k" you are.)
If you do get them (meaning lower deductibles and co-pays) that can be worth $1000s of dollars if you need medical attention.
This is not factored into the above math.

It can be WORTH MAKING A SMALL IRA CONTRIBUTION to pull yourself under 250% FPL

You have the option of using a HDHP bronze plan, possibly with HSA option - this would make the 400% FPL scenario look mildly better with lower premiums. 


Caveats:
My math could be wrong, I just cranked this out in 10 minutes so please triple check
Here is my spreadsheet:
https://www.dropbox.com/scl/fi/c32m3i9yfax0g67qq7zlp/upperwestmike_inheritedIRA.xlsx?dl=0&rlkey=7leunluekkeeq85jd8dnbplvu

If my ACA premium assumptions are off, the numbers shift. Perhaps substantially (a few percent)
This is critical.

Conclusions:
Were it me, I might go for the giant lump sum in 1 year and pay the extra ~0% tax for simplicity.
Then I would work to ensure I get CSR subsidies in the remaining years (<250% FPL.)

Doing this in a 20% down market has a silver lining (maybe withdrawing $200k instead of $250k?) AND we shift the future gains from a down market from ordinary income (IRA withdrawals) to long-term capital gains.

[theupperwestmike]

Holy cow, thanks for much for putting all that time into that reply!

I need to read it a few more times to fully absorb everything, but since you wrote "at most you are paying ~$2k/yr for an ACA silver plan" and also "If my ACA premium assumptions are off, the numbers shift. Perhaps substantially", I want to interject and say I'm paying $9,600/yr for an ACA silver plan.

(Yes, it's the most expensive Silver plan in our area, but it's the only one that has a specialist in their network that my wife wanted, and it's the only national plan and we wanted reassurance when snowbirding in the winter.)

So before I dive in, does this fact substantially alter your analysis?

[gocurrycracker]

No worries, that is what the forum is here for


If I understand correctly, there is a silver plan (the 2LCSP) available to you that costs about $160/month but you opted into the $800/month plan?

OK, let's go from there. What matters is the delta from going over the subsidy cliff, either at 400% or 600% depending on the year. Coincidentally, that remains roughly the same so the analysis conclusions are the same.


I added a 2nd section to the spreadsheet using the new ACA numbers

[theupperwestmike]

Sorry for the delay, life got in the way with me being able to put my focus on this the past few weeks.

Gosh, it sure seems like taking the lump sum in a single year is the way to go.

- it wins for simplicity and not having to remember to recalculate things every year
- it's net tax rate meets my judgement of "close enough!" to the other options
- we have the free cash to pay the tax due
- in a down market, it's not a bad time to take a distribution from an IRA

If we did it during the 2022 tax year, wouldn't we owe an underpayment penalty of 3% Federal and "up to 10%" state (Illinois)? So we would have to do it for the 2023 tax year and pay estimated taxes along the way next year? (Or likely Vanguard can withhold taxes for us).

It would have been nice to do it during the 2022 tax year because we *are* eligible and have been enjoying CSRs, and we wouldn't have to pay them back come tax time (in my understanding). But I can't think of away around the harsh underpayment penalties.

I also have a nagging feeling there's another factor or two we should be considering in our decision, but I haven't come up with it yet. I'll keep thinking.

(As I typed that I thought that while we rent, we might want to buy a home, and with mortgage rates around 7%, maybe having a nice pile of cash laying around to put toward - or pay for a home outright - might be a blessing. Another in the "pro" column for taking a big distribution up front.)

[gocurrycracker]

What is the underpayment penalty you are referring to? For underpayment of estimated tax?

I don't know IL's rules, but for federal it is easy - the tax is due as you go... if you realize a large chunk of income on December 31st, that is due with the estimated tax payment on Jan 15. No need to pay in January '22 because you think you will have a big income jump in December '22.

But even that may be unnecessary and you can just pay in April as long as you make estimated payments equal to or greater than 100% of the tax you owed last year... which is what, $0?
https://www.gocurrycracker.com/avoiding-tax-penalties/


You shouldn't have to pay back any CSRs but you will have to repay the PTCs in full when you go over 400% FPL (edit: 600% FPL)


Do you concur with the #s in the spreadsheet?

[theupperwestmike]

Ah yes, you're right, I was just thinking of a big "taxed owed" number come April and was assuming there'd be a commensurate penalty. I didn't think it through. We will have had more taxes withheld from our "fun jobs" than the tax we owed last year (that's line 24 on form 1040, right? If so, that's $155 for us.)

In researching Illinois underpayment penalty rules, I was reminded that Illinois is generous to retirees in that they don't tax withdrawals from retirement accounts, so no worries there!

As for your spreadsheet, yes, your numbers make sense. With withdrawing the funds this year, the repayment of PTCs would also be a factor (for those scenarios over 400% FPL, we have to pay it all back, but paybacks are limited at lower FPLs), but wouldn't be big enough factor to change my mind.

I'll keep thinking about "other factors" but unless I come up with them, I think I'll pull the trigger on a 2022 full distribution. Thanks for helping us flush out the scenarios! It was a surprising result for me! I would have guessed that a scenario like withdrawing up until the 400% FPL or 12% tax bracket each year would have come out on top.

[theupperwestmike]

Hi Jeremy,

One new factor that just came to mind that I didn't think of earlier (maybe you did, but I missed your mention of it):

If we take all $250k from the inherited IRA into our taxable account year 1, and invest it in vanguard funds paying about 2% in dividends, we'll have another $5,000 in income each year. So it's not like I can just go back to my usual income and ACA/tax planning as it was before in my years 2-10. We'll have a taxable income of ~$50,000 a year instead of ~$45,000 a year. Luckily we have some earned income, so if we want to shoot for those sweet CSRs, we can contribute to an IRA each year to get ourselves down near that 250% FPL number**. But any Roth conversions and capital gains harvesting would become near impossible.

This CSR part doesn't apply to everyone, we just happen to be at that threshold, but paying a little more in ACA tax years 2-10 would be universal by taking the $250k in year 1. Perhaps taking it in year 10 makes more sense? Then again, it's probably just a fraction of a percent difference in overall tax rates.

Am I thinking about this right?

** Since the FPL numbers are derived from the CPI, with current inflation levels, maybe the FPL levels will increase a good chunk over the next couple years and soon a $50k income for a family of 2 will be eligible for CSRs.

[gocurrycracker]

Let's look at the 2 extremes

If you take it all out today you pay about $60k in ACA premiums and income taxes, so you will have about $190k remaining to invest in accordance with your target asset allocation.

If you wait 10 years and do a large withdrawal at the end, assuming 7% annual return you will make a $500k withdrawal with marginal rates up to 35%+/- (total tax ~= $113k.)


At the same time, that 190k may have grown to $380k or so (same 2x.) 


Total value is roughly the same in both cases - in the former the $60k in taxes not paid gets to grow longer but then you pay taxes at a higher rate on withdrawal.
In the latter case you have a bunch of unrealized capital gains which may never be taxed, and you will have taxable income from dividends / interest along the way. As you say, more income means higher % FPL which may impact CSR. Independent of this choice, dividends can go up and down and many companies have been increasing dividends faster than inflation for some time.


FPL numbers do go up with inflation, but with a delay of 1 year... ACA enrollment for 2023 is based on FPL numbers reported in January 2022