Individual retirement accounts (IRAs) are seeing an increase in size, with the median IRA balance reaching $87,000 in 2022, up from $81,144 in 2019. This growth poses potential tax challenges for retirees and their children who inherit these assets. A report from the Employee Benefit Research Institute revealed that a considerable portion of IRA assets are held in rollover IRAs, funded through past employer plans, while only a small percentage are in Roth IRAs, which do not trigger taxes upon withdrawals.
While accumulating a larger pretax IRA balance is generally positive, it can lead to tax complications in retirement. Withdrawals from traditional IRAs are subject to regular income taxes, based on an individual’s tax bracket. As pretax balances grow, retirees may face larger required minimum distributions (RMDs), which could result in increased tax liabilities, including higher Medicare premiums.
Beginning in 2023, most retirees must commence RMDs by age 73, a deadline extended to age 75 starting in 2033 under Secure 2.0. However, some experts argue that Congress’s decisions to postpone required withdrawals only serve to exacerbate the issue, as larger pretax balances will persist, leading to even greater RMDs in the future. To mitigate potential tax burdens, financial advisors often recommend Roth conversions, which involve transferring pretax or nondeductible IRA funds to a Roth IRA, particularly beneficial during lower-income years.
The growth in IRA balances also presents tax challenges for adult children inheriting their parents’ accounts. Recent changes in tax legislation, such as the Secure Act of 2019, have altered the rules surrounding IRA inheritance, giving most heirs a 10-year window to deplete inherited IRAs, as opposed to the previous option of stretching withdrawals over their lifetime. This compressed timeframe can be especially burdensome for heirs entering their peak earning years, potentially resulting in significant tax implications for inherited pretax accounts.
The increasing size of individual retirement accounts poses significant tax challenges for both retirees and their heirs. With larger pretax balances leading to higher RMDs and potential tax consequences, careful financial planning and strategic decisions, such as Roth conversions, are essential to mitigate the impact of these accrued tax liabilities. Additionally, adult children who inherit these assets must navigate the changing landscape of IRA taxation laws to ensure they maximize the value of their inheritance while minimizing tax burdens.