Inherited IRA non-spouse (how to distribute tax efficiently)

[mapaww]

My daughter was the beneficiary of an inherited IRA from her grandfather over 10 years ago when he passed away. He -- and we as parents -- fully intended for these funds to be used for college tuition expenses (as it happens, private tuition). Our daughter is 20 and remains our dependent. We fully planned for tuition to come from these resources, even though we are supplementing with a 529. The question is, how do we minimize her tax burden on the IRA distributions since we are in a 32% tax bracket? She is heavily penalized by the IRS by our income level (kiddie tax!), and the college heavily penalizes her (no financial aid) given the IRA assets in her own name. What is the most tax strategic way to distribute her IRA? It seems very challenging to minimize her taxes owed on distributions. I know we are in a fortunate situation, but this directly pits my own retirement against her college tuition, and seriously erodes the IRA funds available for tuition given the tax treatment.

[fanfare]

As you noted, the IRA is controlled by the daughter, and any distribution goes on her tax return.

Since she is no longer a minor, she can use the funds any way she wishes, education, travel, automobiles,  etc.

[NCperson]

@mapaww - the challenge with RMDs is there is no way to distribute efficienty.  it just has to occur and ger reported on your daugther's tax return. There is no 'wiggle' room or alternative approach. 

is she taking the absolute minimum?  that should only be 1.5% or so of the IRA balance, so if that is the case, the IRA is quite large (as she is creating kiddie tax issue) and will continue to reap benefits to her over her life. 

the kiddie tax doesn't kick in until she has income of $12,950 and unearned income exceeding $2300.  

How large is this IRA? 

Her best strategy is thanking Gramps in prayer each night for being so wonderful to her and setting her up for life.  The IRS will do similar as her 32% 'partner'. 

ps the decision for Gramps to leave the IRA to his granddaughter and not his children was the most efficient tax strategy....because it permitted his granddaugher to distribute the RMDs over HER long life and not the shorter life of her parents.  

[dmertz]

As NCperson said, there is no avoiding taking RMDs.  What your daughter can do it take no more from the IRA than is necessary until she is no longer your dependent and the income would no longer be subject to kiddie tax.

[fanfare]

"take no more from the IRA than is necessary "

What is necessary is money for tuition.

[fanfare · Accepted solution]

student loans for tuition,

then pay off the student loans from the IRA over several years four years later.

@mapaww 

[Opus 17 · Accepted solution]

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Under the rules in place in 2012, the beneficiary can choose to spread out the IRA over their lifetime.  They must withdraw at least the minimum amount, but can withdraw more if needed.  As I understand the rules, the child will be subject to the "Kiddie tax" until they are 24, even if they are not a tax dependent.  

While the child is subject to the kiddie tax, it might make sense to take out loans for school, then pay off the loans once the child turns 24.  The interest for 3 years might be less than the tax savings, but this would have to be carefully calculated.

Once the child is over age 24, what is the goal?  She can leave the money until her own retirement and only take the RMD.  If she wants to withdraw more (to invest in other instruments or to spend) she needs to keep an eye on her tax brackets.  Withdrawals may be taxed at 12% or less (or even tax-free) depending on her other income, if you keep the amounts low.

But she must take the RMD and pay the tax, there are no tricks to avoid this. 

[mapaww]

This is a very interesting option that we will explore for next year as that is when we will need to dip into the IRA for the $70k/year tuition. Thank you!

[mapaww]

Thank you, this is very helpful. At $70k/year tuition, there will be nothing left after school. College tuition was the entire goal. The loan route is the most interesting option.

[NCperson]

@mapaww - remember that loans come with interest that eat up the savings.

Let's assume you find an institution that is going to lend your daughter $70,000 for a student loan for her JUNIOR YEAR of college.  Let's further assume the interst rate is 6% in today's environment (that may be quite low - not sure).

She is in a 32% tax bracket today (because of the kiddie tax).

if she lands a job out of college that puts her into the 22% tax bracket (approx. $53k-103k of gross income) and she distributons $70k from the IRA to pay off the loan, that IRA is taxed at 22%, but then you have two years of interest payments at 6% each year, so the 'tax' is 34%! (I added 2 years at 6% each year).

Now if she gets a job that pays less than $53k and the tax bracket is 12%, it begins to make sense to take out the loan while in college....

good luck!