How to reduce your heirs’ tax burden on inherited IRAs and 401(k)s
The stretch-IRA strategy largely went away after the SAFE Act of 2019, leaving heirs with less maneuverability over taxes. There are some solutions for financial professionals.
Baron’s Description: Dreamtime(5)
Text size
When parents leave an inheritance to their children, the assets are often divided equally among the siblings. But it’s not always equal when they leave individual retirement accounts or 401(k)s to grown children with big differences in income—at least not anymore.
Before the SAFE Act of 2019, adult children who inherited retirement accounts had significant leeway in controlling annual withdrawals and the resulting taxes. Although they must withdraw some money each year and pay taxes, they can limit those taxes by spreading those withdrawals over a lifetime.
Now, for most adult children, IRAs and 401(k)s must be drawn within 10 years of a parent’s death, meaning withdrawals—and taxes—can be substantial whether distributions are taken at intervals or in lump sums. By year 11.
Because the new rules could impose higher taxes on adult children, especially high earners, some financial planners are advising parents to keep their children’s income and unique tax status in mind when naming beneficiaries on IRA or 401(k) forms.
Instead of slicing an IRA or 401(k) into equal parts, financial planners like Timothy Steffen are suggesting that parents consider providing higher-income children with more equal inheritances on an after-tax basis than their lower-income siblings.
Steffen, director of tax planning at Baird Private Wealth Management, provides this simplified example of the consequences of not keeping taxes in mind. Consider two adult brothers—one in the 35% tax bracket and the other in the 22% bracket. His mother has $2 million in a traditional IRA, $1.25 million in a Roth IRA and $1 million in non-retirement accounts such as savings and brokerage accounts. They want to be fair, so they fill out beneficiary forms so each account is split 50/50 — leaving $2.125 million for each child.
When children inherit, A son in the 35% bracket ends up with a value of just $1.775 million, up from an original $2.125 million. But the son in the lower tax bracket ends up with a net worth of $1.905 million. In other words, the mother left one son with $130,000 less than the other son after accounting for the impact of taxes.
If the mother wants to avoid this blow to heredity, there is a possible solution, Steffen said. A mother can leave the entire traditional IRA to her lower-income child, the entire Roth IRA to a higher-income child, and most of her savings and brokerage account to the higher-income child.
Reason: Roth IRA withdrawals are never taxed. So even though the rich son has to empty the Roth within 10 years of his mother’s death, he doesn’t have to pay any tax on it.
Consequently, in this simple example based on the sons’ initial tax brackets and income, both siblings receive the same inheritance on an after-tax basis.
To be sure, Steffen says, this approach requires more attention than some parents are willing to devote. If they have money left in an IRA when they die, some parents say: “It’s the kids’ problem,” Steffen said. Others say: “I don’t want my kid to lose $1 million. I will fix it. “
When parents want to adjust beneficiary allocations based on children’s income and taxes, Steffen says it’s not a “set it and forget it” strategy. Beneficiary designations should be reviewed annually so they can be revised if there is a significant change. For example, over time, a wealthy child may lose a job or a low-income child may move into a higher-income career.
Even if parents want to divide all their accounts equally among their children, parents have options to minimize the taxable hit to their heirs.
One option: Parents can convert some IRA funds into Roth IRAs, Steffen said. But before making any conversion, parents should realize that they will pay income tax on anything moved from an IRA to a Roth in a single year, so it’s best to make the move before or during retirement in relatively low tax years. What’s more, it may not make sense if the parents are in higher tax brackets and the children may be in lower tax brackets when they eventually inherit.
Another option for parents with traditional IRAs and Roth IRAs is to tap the two types of retirement accounts differently, so heirs end up with a more tax-friendly Roth inheritance. Parents can take their retirement spending money out of their IRA each year and preserve the Roth and pass it on to the children tax-free.
For some parents with limited resources or a need to reduce their annual taxes by withdrawing some money annually from a Roth and IRA, conserving a Roth may not work. But parents with enough money in traditional IRAs can use the Roth separately for living expenses and charitable contributions while reserving a Roth for a possible inheritance for their children.
Write to [email protected]
