Pay Now or Pay Later?

Pay Now or Pay Later?

[Jackie (not her real name) made this request via the “Ask the Advisor” tool on our website. I obtained her permission to share it on this blog because it has such an interesting educational twist to it.]

Hi Samuel,

I inherited about $55,000 of my father’s IRA and was intending to pay all the taxes this year and be done with it. But my father’s financial advisor and another advisor at my bank think I will pay too much in taxes by doing that. Instead, they suggest that I do a stretch IRA. I am 49 years old, a single mom with two teenagers, and I earn about $68,000 a year. Would you give me your thoughts on this? 

Thank you.

Those who read my columns regularly are quite likely to know my initial response: Let’s gather the facts, and then you can make your own decision. The main issue here is that this lady (or probably anyone, for that matter) does not want to pay “too much in taxes.” Let’s clarify the point by agreeing that not only does she not want to pay “too much” today, but in the future as well. Now that we’ve established that, let’s drill down to the two alternatives, shall we?

The “Pay Now” Alternative

As a head of household earning $68,000 a year, Jackie will have a standard deduction of $8,400 and $10,950 of personal exemptions (for herself and the two teenagers at $3,650 each). This will result in a taxable income of approximately $48,650 ($68,000, less $8,400, less $10,950). Notice that this is the lowest number. However, should she itemize on her Schedule A because she has more deductions to claim, like mortgage interest, charitable donations, property taxes, and the like, that $48,650 taxable income will be even less still.

Here’s a key statement: According to published IRS tables for 2010, a head of household with taxable income between $45,550 and $117,650 will be taxed at a 25 percent marginal rate.

So as it stands now, Jackie’s marginal rate is 25 percent. If she recognizes all of the $55,000 inheritance as income in 2010, her taxable income moves up to $103,650 ($48,650 plus $55,000). Now, the real revelation: What bracket does the new taxable income of $103,650 put her in? You are smart, so you can see that it is the exact same bracket of 25 percent. Incredible, isn’t it? But I told you it has an interesting twist…

Given this scenario, she would pay 25 percent tax ($13,750) today and could save the remaining $41,250 in a completely income-tax free account going forward, and know for certain that she is done and does not have to worry one bit about future tax rates. Not to mention that – under current law – if she happens one day to pass this money on to her children, they’ll owe no income tax whatsoever.

What About the Advisors’ “Stretch” Alternative?

According to the IRS’s Single Life Expectancy Table for Inherited IRAs, this 49-year-old woman will be permitted in 2010 to withdraw $1,567, as opposed to the entire $55,000. The question – and this is a really good one – is: At what tax rate will this little tiny, itty-bitty amount be taxed? The shocking but 100 percent correct answer is – are you ready for this? – 25 percent (or $392). Yes – the same 25 percent! Pretty interesting, isn’t it?

That therefore leaves the rest of the money still untaxed, and therefore yet-to-be-taxed at future (and unknown) tax rates. Again, you are smart, so you realize that by doing this, Jackie would be making a very unwise gamble that her tax rate will remain that low (or somehow even lower), because otherwise she would have made a very bad move. Remember she is claiming two teenagers today who, in a few years, will no longer serve as a tax break for her. But guessing by what these two advisors are proposing, they seem pretty sure that today’s incredibly low rates will stay that way for a very long time – or even better, they expect tax rates to be lowered in the near future. All I can do is to wish them good luck on that frankly naive gamble.

My bottom line in situations like these is that you decide for yourself. But make sure you talk with professionals who have a real track record of knowing how things really work, because a large number of advisors apparently live on another planet.

Visit our Web site to ask YOUR question or call us today at 301.949.4449 to schedule a complimentary session with one of our knowledgeable advisors to discern the best move for your inheritance or other retirement income planning needs.