By: Paul Morrone
After decades of hard work and disciplined saving, high earners who embraced the workplace retirement plan – and the tax saving pretax deferrals that went along with it – have seen their account balances skyrocket as equity markets continue to run up. Those who contributed early and often likely saw their balances balloon into the 7 figures by the time they reached their 50s. Given another 10-15 years to retirement, those individuals may be faced with the financial planning conundrum of the mega IRA. When tax deferred balances fall into the high 7 and 8 figure ranges, a host of planning challenges emerge that require special attention to efficiently manage, distribute and pay tax on these unique assets. More money, more problems, as they say.
A reasonable assumption can be made that someone who has accumulated funds at the level that can be a mega IRA – which we will define as a retirement account with $5.0mm or more for purposes of this article – was likely a high earner during their career and benefited from making tax deferred contributions to their plan. But the better the party, the worse the hangover, and the sobering reality is that the amount of that big retirement account you can actually spend is only about 70% (likely less, especially for taxpayers in high tax states) of what you see on the statement because of the tax expense. If that comment hits home, the time to plan is now and there are some meaningful steps you can take to make your personal balance sheet far more tax efficient in the years and decades to come. This means doing both short- and long-term tax projections to determine the most efficient management strategy to maximize the value of your retirement assets for you and your heirs.
Time is your biggest asset when planning for retirement accounts, because there is the line in the sand in the future when you’ll have to start withdrawing from your accounts due to the required distribution rules. These mandate account distributions begin at either age 73 (for those before 1959 or before) or 75 (for those born 1960 or after), with the amount of the distribution being roughly 3.7% of the account balance at the beginning of the year. Now this may not seem like much at first pass, but an individual with a $5.0mm IRA would have a $188k RMD to be taken that year! For tax purposes, this puts a married taxpayer solidly in the 22% marginal bracket right out of the gate – and this is without any other sources of income (portfolio interest and dividends, pensions or social security, to name a few).
Early retirees or those with a gap in earnings may have the most opportunities to take advantage of creating planning strategies, such as ROTH conversions (whereby pretax assets are converted to ROTH with the account holder paying income tax on the amount converted) by accelerating income into years when their marginal tax brackets are low without worrying about the impact on the taxability of their social security income or Medicare premiums.
Those charitably inclined have more options to tax efficiently withdraw from their retirement accounts when drawing income from their mega IRA. This is because the tax code allows for tax free distributions when a taxpayer wants to support qualifying charities. There are several ways to accomplish this, but charitable giving – and the desire to irrevocably gift assets to charity – must be aligned with your goals. This includes evaluating where your assets are located (IRA vs 401k), how much you want to give and when you want gifts to occur. In many cases, cash gifts to qualified charities via qualified charitable distributions (QCDs) made directly from an IRA prove to be the simplest option, however, those with higher net worth or unique needs may consider some advanced tax and estate planning utilizing strategies such as donor advised funds or charitable trusts as well.
The planning requirements for mega IRAs don’t stop with you. It impacts your beneficiaries, too, and arguably to a greater extent. Picture this – you pass away with $5.0mm in your IRA. Assuming there are no special circumstances that qualify your child from receiving favorable treatment, they will have 10 years to distribute these funds (i.e. pay tax on them). With a normal life expectancy, it is not unreasonable to assume that your child could feasibly be in their 40s, 50s or 60s (meaning their peak earning years) when they inherit your wealth. Market returns aside, this can equate to $500k or more added to their taxable income each year if distribution are spread ratably over the 10-year distribution window required by the current rules. Or worse, without proper planning they may delay taking any money out and be forced to take substantial, potentially 7-figure, distributions if they wait until the end of the 10-year window.
The point to emphasize here is that planning for mega IRAs is an exercise in tax and income planning for both you and your children. Your income needs, tax plans, charitable intentions and estate planning goals all must be considered over a very long time horizon to make educated and proactive decisions on how to best divest from your retirement account balances. Moreover, inadequate planning or simply not addressing the tax-deferred ticking time bomb can lead to an undesirable outcome for both you and the next generation.
Tracking: 1102277
