IRA Legacy Planning

IRA Legacy Planning: Who Will Pay the Taxes?

Who is going to pay the taxes? IRA Legacy Planning

IRA Legacy Planning: You will die, when you do, who is going to pay the taxes on your IRA? You, Your Spouse or your Kids? Someone will pay the taxes.

Taxes, after all, are usually a retiree’s largest expense. Thinking now about who will pay the taxes means tax planning for future after deciding your goals. A goal many folks don’t think about —who will pay the taxes?

Do you and your spouse want to pay the taxes, or leave them for the kids to pay? What about if one of you dies prematurely? Should you optimize your IRA for life as a widow or widower?

What about if your goal is to leave money to charity?

IRA Legacy Planning is an important once you have determined you have enough to safely retire. After all, it is no fun paying more than you have to in taxes, so why not optimize your IRA?

IRA Legacy Planning and Goals

What are some common goals for the IRA?

First, if there are two of you, you should plan for a long life for both of you. Importantly, however, there are major tax and income implications at the death of the first spouse, and you need to make sure your IRA will survive the death of either spouse. This is called the widow tax penalty and it requires consideration if one of you should die prematurely.

If there is enough to go around, then optimization includes considering leaving money to your children and/or to charity. Qualified disclaimer Estate Planning is important (and easy!) to consider first.

Let’s look the goals of your IRA when we consider IRA Legacy Planning.

Charitable Intent and IRA Legacy Planning

If you have charity as your legacy goal, then planning becomes fun and easy! Spend what you want and leave the rest to charity.

Or, with some IRA Legacy Planning, pay less in taxes during your lifetime in order to leave more to charity.

Once you have a future tax projection in place, see what your Required Minimum Distributions will be in the future. Now, mitigate your RMDs and keep you in an optimal tax bracket during your lifetime via Tax Bracket Arbitrage.

Options are:

QCDs –

Instead of recognizing your RMDs as income, once you are 70 ½ (the SECURE Act didn’t change the age you can start QCDs) you can give your pre-tax money directly to a qualified charity. If you do, you don’t need to recognize this money as income. This can keep you in a lower tax bracket, in addition to many positive downstream effects like decreasing taxation of social security, decreasing IRMAA surcharges, keeping tax credits that would otherwise phase out, etc.

Partial Roth Conversions –

If you are going to be in a much higher tax rate in the future, but your plan calls for some extra tax-free income later in life, consider partial Roth conversions. However, remember your “heir’s” income tax bracket is ZERO (charities don’t pay tax on pre-tax money!) so be careful not to overdo Roth conversions.

Charitable Remainder Trusts –

CRTs are an important tool! If you are giving your nest egg away to a large institution, they almost certainly retain estate lawyers who would be more than happy to help you set up a Gift Annuity or Charitable Remainder Trust. These can be effective ways to generate (taxable) income during your life, while getting a present-day tax deduction based upon your future expected gift.

Basis in Brokerage Account –

Remember that charities also don’t pay capital gains taxes, so gift them equities with high basis (large embedded capital gains) while living or in your Will.

Giving your nest egg to charity is fun, but hard work if you want to optimize your nest egg. Let’s move on to a more difficult discussion: nest egg optimization for couple or a single spouse

IRA Legacy Planning for Couples

Who is going to pay the taxes? A couple, or a widow/widower? There can be massive tax implications.

Let’s consider a couple for the time being. They don’t have significant goals to give money to their children or charities, but want to have a comfortable retirement.

Here, it really makes sense to optimize taxes for three different scenarios: Both have long lives, or one or the other passes on early in retirement.

It is important to consider the Widow Penalty. With the Widow/Widower Penalty, if you just plan for long lives for both, one spouse may have to deal with significant financial pressures right at the time they are grieving for their lost spouse.

Single Spouse IRA Legacy Tax Planning

One spouse will die before the other spouse. This has important planning implications! If there is a pension involved, what is the survivor benefit?

In addition, we know once a spouse dies, the smaller social security check will stop coming in the mail. This can have major implications if both spouses earned equally during their working lives, as half of social security income may dry up.

Income will decrease, but many fixed expenses remain! A house doesn’t get a cheaper to maintain if there is only one person living there. Food costs go down a bit, but generally expenses stay around 80% of pre-death levels.

And taxes increase! You get tax bracket compression when you file as a single filer!

This Widow’s Penalty can be expensive! Less coming in, more taxes… this can lead to a plan failure. So, who is going to die first? Who knows! Just have a look at early death of either spouse and make sure the plans support the widow or widower during the rest of life.

Here are the considerations:

Income—

Look at all sources of income and see if any get a hair cut (or amputation!) at the death of a spouse. Almost certainly, social security income will decrease. Pensions, annuities, and other income streams need to be evaluated.

Expenses—

Taxes will increase with the death of the first spouse. In addition, IRMAA surcharges are likely to go up as well. Though there may be some expenses that decrease (like that second car), Long-Term care spending is almost double for the second spouse as there is no longer a caregiver at home.

IRA Legacy Planning for the Children

If you want to leave the most possible behind for your children, consider permanent life insurance for the death benefit. Not infrequently, this would be a second to die guaranteed universal life insurance policy with no cash value.

If you want to stay away from life insurance, consider partial Roth conversions. Of course, here, you need to be concerned with what your children’s future tax rate is going to be. Due to the death of the stretch IRA via the SECURE Act, no longer can they stretch out their inherited IRAs, so consideration for Roth conversions becomes even more important. Review this important concept in the 10-year rule and your Retirement Accounts.

You don’t want to convert at a high tax bracket for a low-income heir, however. Why pay taxes now when they can pay less taxes in the future?

If you have high income and low-income children, consider leaving your pre-tax account to the low-income children and your Roth and brokerage accounts to high income children.

Leaving Money to your Heirs is a complicated topic that will take some IRA Legacy Planning.

Pre-Tax Accounts and IRA Legacy Planning

IRA Legacy Planning

Figure 1 (IRA Legacy Planning)

Much of the consideration for IRA Legacy Planning comes from the pre-tax account. As this money is always going to be taxable unless left to charity, it is most important to consider what to do with your IRAs, and 401k/403b plans.

In addition, Required Minimum Distributions force this money out. Initially, there are only small minimums, but over time, these distributions can force you up into the very highest tax brackets if you have large pre-tax accounts.

You want to spend down or convert you pre-tax money if the accounts are large, or if there is a chance you will be a single spouse subject to higher tax brackets. In addition, if your heir will be in a higher tax bracket than you are currently in, Roth conversions make sense as well.

On the other hand, you might consider deferring spending from these accounts if your heir is in a low tax bracket or if you have charitable intent. If nothing else, consider de-bulking your IRA via Partial Roth Conversions.

So, who will pay the taxes?

 

Who Will Pay the Taxes? IRA Legacy Planning

First off, understand that this question is only intended for those with plenty of money left over. If you can comfortably spend from your nest egg and will have left overs, then you can worry about the taxation.

But understand this: Taxes will be paid. Doesn’t it make sense to think about the lifetime taxation of both you and your spouse, AND your future heirs? This is IRA Legacy Planning

So, when you plan for death and who will pay the taxes, need to decide who to focus on. Your goals and priorities determine who is going to pay the taxes now and in the future.

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2 Comments

  1. Now that the stretch ira is taken away, it seems that it might be better to spend that down as much as possible if you are planning to leave a lot of money to your heirs.

    At death the heirs should get a step up in basis so all capital gains tax would be eliminated from the inherited Brokerage account for example (or real estate)

  2. If you invest in real estate directly, buy your own rental properties, you can avoid the taxes altogether on the appreciation. There are two ways. You can do 1031 exchanges and keep moving the appreciation forward to a new property. Then you can pass it on to your children who will get it at the new face value and not pay any taxes on the appreciation. This can go on forever. There might be some inheritance taxes, but that is not directly attributed to the property. If you don’t know how to get started in real estate you can pick up my book that spells it out.

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