Let’s look at the substantial tax increases for younger inheritors. Assume grandma passes with a $100,000 IRA. Last year, her daughter would have inherited it at age 50 and was able to spread the income over her life expectancy of 34.2 years.[1] That means that first year less than 3% of the inheritance is income-taxable. The daughter’s taxable income is $86k, and so she pays 24% on that $3k, or $701 income tax.

Each year thereafter, she’s required to reduce that starting number (34) by a year. She’ll be able to invest the remainder of the inherited IRA, and continue the tax deferral. In our example, she’s also going to invest the proceeds from the forced distribution in a taxable account that is either taxed at a (almost always lower) long-term capital gains rate or her income tax rate. Then, every year, she’ll need to make a new taxable distribution.

If our daughter-inheritor earns 7% on her money, then during her 34 years of life, she can figure paying approximately $86,000 of taxes. By the end of those 34 years, she’s very likely spent the account to zero value.[2]

Her new account will require her to pay between $108,000 and $89,000 in taxes, depending upon whether she was taxed at a long-term rate (at best only once, at the very end of her life) or (at worst) it is income-taxable every year. By deferring and controlling how much and when she pays taxes, she’s able to turn this inheritance into between $726,000 and $526,000 over her 34 years life expectancy.

As we’ll see below, this is a big increase in spendable money over her lifetime. And the benefit gets much larger for her grand-daughter who will inherit that money, and do the same thing. The old way—the stretch IRA—gave the benefits to the second inheritor as well. The new law does away with that benefit. The taxes the government collects add up quickly.

Imagine the first inheritor dies with $100,000 in the IRA, so her daughter (grandma’s granddaughter) inherits $100,000. The same math repeats. In the old way, with the stretch IRA, granddaughter used to pay about $86,000 in taxes over her lifetime on forced distributions from the inherited IRA.

The total three generation—grandma plus two inheritors—planning opportunity used to be huge. They could plan on total distributions of $526,000 (or significantly more) over two inheriting generations. If granddaughter inherits that $526,000, and invests at the same 7% rate of return, then she may have between $4 MILLION and $6.7 MILLION by the end of her life!

Compare this situation with the new tax rules and you’ll find we’ve just lost a huge tax benefit—we will pay more taxes—and we’ll likely have less money across generations. Taxes just went up.

The new way—no more Stretch IRA, but more taxes

Now that the Stretch IRA is gone, our inheritors must spend the money within 10 years. Many of the inheritors are in a higher tax bracket than the decedent, and this is a win for the government and a loss for us taxpayers. Because many inheritors are still working and not yet retired (living off a fixed income), the IRA inheritance is taxed at a higher income tax bracket. This is a hidden tax increase.

Let’s look at our same example. Grandma passes away with $100,000. Now her inheritor-daughter has to pay income taxes on all $100,000–which may bump her into the next highest tax bracket, which makes the situation possibly worse than shown below!

Let’s be conservative and assume the daughter works with her wealth manager here at AIFS and she keeps her taxable income in the 24% tax bracket. For her $100,000, she may need to spread the inheritance out over multiple (but not more than 10) years. The IRS allows us to do that, and so we reduce her taxes as much as possible at the beginning of her plan.

Daughter pays $24,000 in taxes. She has $76,000 remaining in her inheritance. Assuming she gets the same growth rate as in our previous assumption, then she will pay taxes on the growth each and every year she is alive. She will either pay long-term capital gains rates or income tax rates, so her tax burden will vary greatly, between $95,000 and $109,000. In the old regime, this was approximately $86k for an estimated lifetime tax burden. That’s the first tax increase.

She might expect to have between $709,000 and $428,000 at the end of her 34 year life expectancy, when her plan was between $726,000 and $526,000 in the old regime. There is the second tax increase—less money to spend over her lifetime.And what about the granddaughter? She inherits a taxable account instead of a tax-deferred IRA, and so she has to pay taxes each and every year. Because, in this example, it’s not a retirement account she gets a step-up in basis, and that simplifies her life. But she could have had more money and paid less in taxes under the old rules.[3] The amount of tax benefit lost by the second generation of inheritors could easily surpass the initial value of the IRA. Ouch.

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[1] IRS Publication 590, Appendix B, Table 1 Single Life Expectancy. I like the version found here: http://personal.fidelity.com/products/retirement/inheritedira/lifeexptable.html

[2] Assumes her investment amount and income tax rate don’t change, or decline. For details, email your wealth manager.

[3] Future value of mom’s $76,000 after-tax inheritance for 32 years at a 2.28% rate, which is the rate less the 24% tax burden).