In a recent effort to come up with funding for a new federal highway bill, Senator Max Baucus, (D – Mont.), proposed eliminating the tax deferral on inherited IRAs. As things now stand, one who inherits an IRA can “stretch out” withdrawals over one’s actuarial life expectancy. The proposal Baucus floated would require that inherited IRAs be withdrawn in full, and income taxes paid on them, within five years of the original IRA holder’s death. The only exception would be for the IRA holder’s spouse, who could continue to make the deceased spouse’s IRA his or her own and take withdrawals over his or her lifetime.
According to Bloomberg News, Baucus said, “IRAs are intended for retirement,” claiming the current law is being abused. “They’re being used by some taxpayers to give tax-free benefits to future generations.” Excuse me, Senator, but you know that statement is false.
IRAs (excluding Roths) are never tax-free; they’re only tax-deferred, and that’s a big difference. Consider presidential candidate Mitt Romney, who reported that his IRA is valued somewhere between $20 million and $100 million, apparently because he parked stock in his Bain Capital investments there. While he was able to defer a small amount of tax at the time of contribution, he must begin annual withdrawals in 2017 when he reaches age 70-1/2, which will constitute ordinary income for tax purposes.
Assuming Romney’s IRA is worth $50 million on December 31, 2016, he must withdraw about $1.825 million in 2017, on which he’ll pay $639,000 in federal income tax (at a 35 percent rate). But that’s not all. Assuming moderate continuing investment returns of, say, 6 percent annually, his IRA will continue to grow for another 13 years until the mandatory withdrawal rate exceeds the investment return rate. Should he be so fortunate as to live to age 100, his IRA would still be worth $31 million. And the federal government would have reaped more than $41 million in income taxes from him over those 30 years!
In a famous 1972 experiment on deferred gratification, Stanford psychologist Walter Mischel sat children ages four to six alone in a room, placing one marshmallow before each of them. If they could delay eating the marshmallow for 15 minutes, they’d receive a second marshmallow, both of which they could then eat. But if they couldn’t wait, they got to eat only one marshmallow. Of course, only a small minority of subjects could resist eating the single marshmallow before the allotted time was up.
I immediately thought of the marshmallow experiment when I learned of Senator Baucus’ proposal. The principle of delayed gratification works to the benefit of the federal fisc in the case of inherited IRAs just as powerfully as it works with the original IRA holder.
Here’s how: Let’s assume you’ve just retired at age 70, having accumulated $1 million in your IRA through a combination of thrift and wise investing. To everyone’s great misfortune, you die suddenly before ever enjoying the fruits of your IRA. For simplicity of illustration, let’s assume your spouse is gone and you have one daughter, Samantha, age 40, to whom you leave your IRA.
Under current rules, we look at a table in IRS Publication 590 to find that Samantha has a life expectancy of 43.6 remaining years. In the year following your death, Samantha must withdraw just under $23,000, on which she’ll owe federal income tax of $6,900 (at an assumed 30 percent rate). As was the case with Romney, if she invests wisely and generates an annual return of 6 percent, her inherited IRA will continue to grow in value for the next 27 years. At that point, the required withdrawals will overtake the investment returns, gradually depleting the IRA until it must all be withdrawn when she reaches age 84. If the feds can defer gratification, they’ll receive total tax revenues from Samantha (again at a 30 percent rate) of $1.478 million over the next 44 years.
By letting Samantha space out withdrawals over her lifetime rather than withdrawing the entire IRA in five years, the inherited IRA will not only provide more tax revenues for Uncle Sam, but it also will provide Samantha a ready-made retirement account. Given the investment return and withdrawal assumptions I used, the inherited IRA will max out at $1.941 million when Samantha is age 67. If the feds haven’t completely debauched the dollar by then, that should provide Samantha with a very comfortable retirement nest egg. The government will benefit both by generating more tax revenue over the long haul and by assuring that Samantha will not become a public charge at retirement.
Senator Baucus and the other children in Congress just don’t get it. Their hunger for short-term revenue to feed the maw of excessive expenditures violates every principle of sound fiscal behavior. And I fear that Baucus’ proposal is only a warning shot across the bow. Until we see adults getting elected to Congress and the White House, we’re likely to hear an increasing drumbeat for immediate tax gratification with respect to IRAs and other vehicles designed to encourage people to save for their futures.
