The Unintentional Inherited Retirement Account

Chances are pretty good your kids are going to inherit a retirement account from you. “No way!” you say, “I’m spending that on me!” “Way!” I reply.

As previously pointed out in prior posts, your inability to predict the future—how long you will live, what your investments will earn, what financial emergencies will befall you—will lead you to avoid draining your savings buckets dry. Like it or not, inheritance is a by-product of uncertainty.

And if you engage in clever spigot planning in an effort to boost your own retirement spending—as I am sure you will—chances are pretty good the last bucket standing will be a tax-favored retirement account of some kind—either a traditional retirement account or a Roth retirement account, or perhaps some of both.

To put an even finer point on this prediction, chances are pretty good your retirement account (or accounts) will be IRA’s rather than 401(k) or other employer plan accounts. Why? Because somewhere along the way, after you have left employment, you will have rolled over your employer plan accounts into IRA’s, due to the greater control you can exercise over them compared to the potential restrictions of employer plans (as pointed out in February 18’s post).

So your kids are probably in for an inherited IRA despite your best efforts to die broke. What’s it worth to them?

Here’s a little thought experiment. Picture three different brothers, Huey, Dewey and Louie. Each dies with a $100,000 account left to his sole 45-year old daughter, Patty, Maxine and Laverne, respectively. The only difference is that Patty’s inheritance is in an ordinary taxable investment account; Maxine’s is in a traditional IRA, and Laverne’s is in a Roth IRA. These are all different animals, so they are worth something different to the girls. How can we compare their values? Here’s one way. Since the IRS assigns a 45-year old beneficiary a 39-year distribution period, as described in yesterday’s post, we can ask how much of an after-tax inflation-adjusted stream of payments might the different savings buckets be projected to provide the girls over a 39-year period. Using reasonable assumptions, here’s what the girls project:
Patty (taxable account): $4,582 per year
Maxine (traditional IRA): $4,154 per year
Laverne (Roth IRA): $5,934 per year

The results are not terribly surprising. Laverne’s Roth IRA gives her the largest payout (by a wide margin), since she benefits from both a tax-exempt savings bucket and tax-free distributions. Patty comes in second with her taxable investment account; she has to pay tax on her investment earnings, but not on any distributions from the bucket. And Maxine comes in third with her traditional IRA; she benefits from a tax-exempt savings bucket, but the tax she has to pay on distributions outweighs that benefit.

But now let’s look at it another way. What if the girls have other sources of spending, and instead choose to let the inherited money continue to be reinvested? In other words, they’re savers rather than spenders. Maxine and Laverne take IRA distributions only in the minimum amount required by law, and then reinvest the after-tax amount remaining in a taxable investment account. By the end of 39 years, the IRA’s will have been completely distributed into taxable investment accounts just like Patty’s. Then the amount of after-tax dollars the girls project they can accumulate over 39 years will be as follows:
Patty (taxable account): $1,151,334
Maxine (traditional IRA): $1,156,783
Laverne (Roth IRA): $1,652,547

In a surprise reversal, over 39 years Maxine’s $100,000 IRA turns into a taxable account worth (a bit) more than Patty’s $100,000 taxable account. The benefit of the traditional IRA’s tax-exemption, combined with the slow stretching out of distributions, ends up overcoming the detriment of having to pay income tax on the distributions. It’s a miracle!

Either way, your kids’ unintentional inheritance can give them a leg up on their own retirement planning. Rest in peace.