Individual retirement accounts (IRAs) have been growing steadily in recent years, with the median balance reaching $87,000 in 2022. This increase in IRA balances can lead to potential tax issues for retirees or their children who inherit the assets. Experts have pointed out that higher pretax IRA balances can become a “tax nightmare in retirement,” according to certified financial planner Derek Williams.
A report from the Employee Benefit Research Institute revealed that over 45% of IRA assets were in rollover IRAs funded through past employer plans. On the other hand, only around 17% of analyzed assets were in Roth IRAs, which do not incur taxes on withdrawals. Traditional IRA contributions may offer an upfront deduction, but withdrawals during retirement are subject to regular income taxes based on the individual’s tax bracket.
As IRA pretax balances grow, retirees may face larger required minimum distributions (RMDs), which can have tax implications such as higher premiums for Medicare Part B and Part D. With changes enacted by Secure 2.0, most retirees are now required to start RMDs by age 73, which will be extended to age 75 starting in 2033. Postponing these withdrawals can lead to even larger RMDs down the line, creating a potential tax burden for retirees.
To mitigate future tax liabilities, some advisors recommend Roth conversions, where pretax or nondeductible IRA money is transferred to a Roth IRA. This strategy can be particularly useful during lower-income years, as there is an upfront tax on the converted balance. By taking advantage of Roth conversions, retirees can potentially lower their tax burden in retirement.
Impact on Inherited IRAs
Growing IRA balances can also have tax implications for adult children who inherit their parents’ accounts. Recent changes to tax law have made pretax IRAs less desirable to inherit, as heirs now only have a 10-year window to empty inherited IRAs. This change, brought about by the Secure Act of 2019, eliminates the option for stretching IRA withdrawals over a lifetime, potentially increasing taxes for heirs.
As individual retirement accounts continue to grow, it is essential for retirees and their beneficiaries to be aware of the tax implications. Proper planning, including considering Roth conversions and understanding RMD requirements, can help minimize tax burdens and ensure a smoother financial future for retirees and their heirs. By staying informed and seeking advice from financial professionals, individuals can navigate the complexities of growing IRA balances and make sound decisions to protect their wealth.