For many people, this may be a great time to kill a traditional IRA. Dismantle it. Take it down. Cash it in. Or at least start that process and save thousands of tax dollars doing it. Especially as we head into the home stretch of the year.
Many of my financial advisor friends are now on the floor. They think I’ve “gone ‘round the bend.” Don’t worry, friends, I’m going to suggest folks come see you and ask for your help.
But often tax efficiency isn’t the only issue . . . Medicaid and nursing home costs are.
Why Drawing Down a Traditional IRA May Be Smart
Many people have a huge portion of their savings tied up in a traditional IRA. If an IRA owner needs to go into a nursing home, the IRA will be a countable asset and prevent that person from qualifying for Medicaid. The only way she will qualify for Medicaid is by cashing in the IRA and doing other things with the cash.
Had all of the Roth’s assets been liquid (cash, CDs, money market), we would have qualified Ira for Medicaid by moving about $120,000 to Irma, and spending about $80,000 for Irma (home improvements, new auto, perhaps an annuity). But their assets aren’t liquid. Ira has a big IRA.
To qualify for Medicaid, Ira MUST cash-in the IRA. Because a traditional IRA distributions are taxable as ordinary income upon receipt, Ira and Irma will include $150,000 on their joint tax return for 2017. With no other deductions or income considered, the tax bill will be about $29,000. If Ira’s traditional IRA is $200,000, the tax bill will rocket to around $43,000.
Spread The Tax Pain
Had Ira and Irma had a premonition back in 2016 that Ira would be in a nursing home by 2018 and thinking about Medicaid, they could have laid plans for the intentional demise of Ira’s IRA and saved a pile of money. In fact, by killing the IRA slowly over two years they could have lowered the tax bill by over $8,000. If the IRA had been $200,000 they would have saved around $10,000 in taxes!
It has to do with income tax rates. Income tax rates are on a curve. $20,000 taxable income will be taxed at just a bit over 10% . . . $150,000 taxable income will be taxed at 19% . . . $200,000 at almost 25%.
By breaking up income over two or more years, the income is taxed at a lower rate. For example, the tax on $150,000 in one year is about $29,000. The tax on $75,000 is about $10,000. The tax on $75,000 in each of two years is about $20,000, compared to the tax of $29,000 on $150,000 in a single year.
For someone contemplating the real possibility of a nursing home in the next few years, there are still three months to take a planned, but hefty, installment for 2017, then look at distributions in 2017 and maybe 2018.
But Isn’t IRA Murder Always Wrong?
Not When Medicaid Qualification is the Motive!
In our modern, relativistic society the answer is: Not always; it depends. Especially when we’re talking about IRA killing.
I tend to be a traditionalist, and traditional teaching is to leave an IRA alone and to take as little out as possible. The traditional wisdom is based on the math undergirding the federal tax rules that apply to retirement savings.
Uncle Sam says “I’ll let you put money into this thing called an IRA. I may even give you a tax deduction for the money you put in. I won’t even tax you on the investment income and the capital gains inside the IRA. That way your IRA will grow much bigger and much faster.”
And you say, “What’s the catch?” The catch is that someday, somehow someone WILL pay taxes on that IRA. It is never a question of IF, but WHEN. That is why there are all sorts of complicated rules about when someone must start taking distributions and how big those distributions must be. Uncle Sam is impatient and wants his cut.
The beauty of an IRA depends upon two things: The amount invested and time. The more time and the more money someone has to keep an IRA going, the more attractive it will be. On the other hand, a large IRA doesn’t do too much good if it is going to remain invested for just a little longer.
Uncle Sam isn’t completely heartless, and he certainly understands that his tax rates are on the curve I described above. In that case he doesn’t set the minimum amount that an owner MUST take out every year too high.
But when factors other than tax rules start controlling how much must come out (perhaps even dictating that ALL must come out in the case of a nursing home placement with Medicaid) it is time to start thinking outside the tax box.
So . . . RIP IRA. But before you seriously think of killing your IRA, do run it by your financial advisor.