Best Way to leave money to heirs

Best Way to Leave Money to Heirs

Best Way to Leave Money to Your Kids

Inheritance. A goal for some is to leave behind money to their heirs. What is the most tax-efficient way to leave money to your children? What is the best way to leave money to heirs?

If your goal is your kid’s inheritance: let’s look at which accounts you should leave behind, gifting during life, and tax implications of leaving money to your kids. 

Which Accounts Should You Leave to Your Children?

There are three different types of assets from a tax perspective.

These asset buckets are: Never Taxable, Sometimes Taxable, and Always Taxable. Some are more tax-efficient to leave to you kids than others.

Never Taxable

An example of a “Never Taxable” account is a Roth IRA.

Roth IRAs are the best accounts to leave to your children as they will never pay taxes since you already did! In addition, these accounts continue to grow tax-free after inheritance.

Since the death of the stretch IRA via the SECURE Act, these Roth IRAs must be closed before the end of year 10. The optimal way to receive this inheritance is to leave it in the Roth for 10 years and then pull it out at the end..

Sometimes Taxable

“Sometimes Taxable” accounts are brokerage and savings accounts.

When invested, these accounts get a “step-up” in basis when you die. Say you bought VTI at $10 and when you die it is worth $200.

If you sold the fund before death, you pay capital gains tax on the $190 of profit. When gifted during life, the basis transfers with the gift resulting in capital gains taxes.

But your heirs get a full step-up in basis of $200 at your death. Then, they can sell at $200 without paying capital gains.

If you have appreciated assets in brokerage accounts, leave them there until your death rather than giving them away. Then, your kids get a full step up in basis! There are no Required Minimum Distributions on brokerage accounts, but any future growth is taxable.

Consider Upstream Gifting to your parent too in order to get a step up in basis when they die!

Always Taxable

Always Taxable accounts require the most attention.

These “qualified accounts” are pre-tax retirement accounts. Whenever distributions are taken from these account–by you or your heirs–taxes are due.

I’ve included a few advanced strategies to deal with these accounts at the end of this blog.

Other Types of Assets Left Behind

Let’s briefly look at some other assets you leave behind when you die.

Real property gets a step up in basis upon death. Titling of these properties is important and deserves an entire blog of its own. The short lesion: don’t tile these properties as joint tenants with rights of survivorship with your children. If you do so, it only gets a partial step-up in basis.

Bank accounts similarly should not be titled as joint tenants. If you have a bank account, keep it in your name and make sure it has a Transfer on Death designation. This will keep it out of probate.

Stock and mutual fund accounts can also have a Transfer-on-Death designation. They get a full step up in basis and shouldn’t be gifted. If you must stocks, gift the ones with the highest basis as basis transfers upon gifting.

Payouts from life insurance are tax free.

Gifting During Life

It is best to give with warm hands.

Under current law, each spouse can give a maximum of $15,000 a year to a person without having to file a gift tax return. If you give more than that, you won’t pay gift taxes until you reach the $11+ million-dollar estate tax exclusion limit ($22 million for a couple) but you have to file the return with your taxes. If you gift split—a married couple can give up to $30,000 a year to any individual—a gift tax return must be filled out as well.

You can give an unlimited amount to a university or hospital to pay for anyone’s educational or medical expenses as well. Just make the check directly out to the institution.

Also, think about a super-annual gift into a 529 for grandchildren. If married, put in 5 years’ worth of gift tax exclusions into a 529. This is $30,000 x 5 = $150,000 per grandchild. Remember, if grandparents own the 529, don’t use the account until the second semester of sophomore year. This keeps it from counting as income for the student for purposes of financial aid.

Ever thought about upstream gifting? Give to your parents in order to get the step up in basis when they die? Neat idea where no one would ever pay capital gains taxes.

All I Need is a Will, Right?

In short, no. It is important to understand that whenever possible assets should pass outside of probate. Having assets pass via a Will means they go through probate.

Probating a Will can be costly, time consuming, and it is a matter of public records. Assets pass via rule of law, trusts, and beneficiary forms prior to being included in probate. This is a vital topic to understand.

At bare minimum, know the beneficiary forms and have them filled out appropriately. Importantly, a trust not specifically designed for a retirement account is not suitable. Don’t have any old trust named as a beneficiary of an IRA. This will blow up the IRA and taxes will be due on the entire account.

Do I Need a Living Trust?

In some states you don’t need a living trust. Assets can pass on after your death via other mechanisms (see above). If there are assets that you cannot pass on any other way, consider a living trust. With this document, you make the trust owner of assets so they don’t pass via probate. Essentially, you do the work of probate before your death, re-titling the assets to your trust. Setting up the trust is not enough. Assets must actually be re-title into the trust. In some states where probate is particularly expensive or otherwise offensive, living trusts are a smart.

Considerations for your Always Taxable Accounts

If you are a 401k Millionaire, then you have a problem. The IRS will crack open these accounts and tax the deferred income inside them. See my prior blog on The Tax Planning Window as reference, but partial Roth Conversions are a great strategy for gifting to your children.

What if you have a starving artist child in the zero-tax bracket? Or is your child a high-income physician practicing in a high-income tax state? There are different considerations for partial Roth conversions during your lifetime depending on your heir. The goal is to pay the least in taxes over both your and your heir’s lifetime.

Child in the Zero Tax Bracket

If your child has low income, why pay a lot of taxes now to convert to a Roth? When they inherit your IRA, hopefully they will “stretch” it over 10 years to pay the least amount in tax possible.

best way to leave money to heirs

Figure 1 (Low Tax Bracket Heir)

Above is an example of a partial Roth conversion strategy for a couple with an heir in a low tax bracket. You can see in green they retire at age 60 and income drops from the 24% tax bracket to zero.

Note that the tax brackets have two values. The Tax Cut and Jobs Act (TCJA) expires in 2025. Tax rates will go back up from 12% to 15%, from 22% to 25%, and from 24% to 28%. Most people think that the TCJA will not be renewed and taxes are “on sale” currently.

There are two overlapping scenarios demonstrated above. Without partial Roth conversions, see in green, RMDs start once they turn 70. These RMDs kick them up into the 22%/25% tax bracket and once they are 75 years of age, they pay at the 24%/28% tax bracket.

Let’s optimize this scenario for an heir in the zero percent tax bracket. You heir has access to the standard deduction, and the 10% and 12% tax bracket to absorb income from the inherited IRA.

It is not cost effective to convert too much into a Roth IRA and pay large taxes now, when you heir will pay less in taxes later.

In blue, you can see that they do partial Roth conversions up into the 12%/15% tax bracket. This optimizes their own taxes from RMDs, but doesn’t convert too much as the heir can inherit what is left and pay taxes at a lower rate.

Remember, your goal is to pay Uncle Sam as little as possible over both your and your heir’s lifetime.

If you have two heirs in very different tax brackets, consider leaving them accounts accordingly. Your high-income heir can get the Roth and brokerage accounts. Your low-income heir can get the qualified accounts (pre-tax IRAs).

Child in a High Tax Bracket

On the other hand, if your heir makes a lot of income, perhaps you are better off paying taxes now. As a retiree, you may have little income and thus access to your lower tax brackets.

Conversely, In the future when you heir is forced to take RMDs from the inherited IRAs, they will pay tax at their marginal (highest) tax rate.  Again, the goal: pay the least taxes over the combined lives of you and your heir.

leave money to your heirs

Figure 2 (High Tax Bracket Heir)

Let’s think about a child who will inherit an IRA who is already very successful. Assume they are paying taxes at a combined rate of 48%. If you want to leave them your IRA, YOU might plan on paying taxes at your lower rate to do partial Roth conversions.

Again, this couple retires at 60. In green are future expected RMDs without doing partial Roth conversions.

Note in blue that they utilize the 24%/28% tax bracket to do partial Roth conversions prior to RMDs at age 70. In addition, despite the increased taxes on their social security (and other taxes like IRMAA), they continue to do partial Roth conversions into the 22%/25% tax bracket until the entire IRA is converted into a Roth IRA.

If their heir inherits a taxable IRA while in the 48% tax bracket, they pay taxes at the marginal rate of 48%. Meanwhile, during retirement, this couple only pay taxes at less than 24%/28%.

What If Both You and Your Heir are in High Tax Brackets?

This is going to get even more complicated. I’m sorry, but this is advanced stuff.

If both you and your heir are in high tax brackets: leverage life insurance and a Charitable Remainder Unitrust.

I know, permanent life insurance is not popular in physician financial blogs. But, if you don’t need the RMDs from your IRA, yet you and your child are in high tax brackets, this can leverage your Always Taxable money into a Never Taxable life insurance payout.

The basic idea is to get a second-to-die guaranteed universal life (GUL) policy for the death benefit. There is no cash accumulation with these policies. I’ve heard insurance salesmen don’t like GULs as they don’t pay good commissions. Salesmen may also try to sell you on cash value, but what you want is death benefit and nothing more.

Since it is a second to-die-policy, it is less expensive than a single life policy. Use RMDs from the IRA to pay premiums. Upon the death of the second spouse, your heir gets $1-5 million dollars tax free. That’s right, death benefits are tax free! Apparently, these second-to-die policies may have internal rates of return above 5% per year. This is not bad considering you are leveraging an Always Taxable asset into a Never Taxable one.

Next, leave the rest of the IRA into a Charitable Remainder Trust. Without getting too far into the weeds, an irrevocable election to a Charitable Remainder Unitrust (CRUT) can pay income to your heirs for 20 or more years. Generally, depending on the terms of the trust, income is about 5-8% of total assets in the trust. Of course, this money is taxable. And at the end of the term, the remainder (at least 10% of the initial grant) must go to the named charity.

What if the named charity is your heirs’ Donor Advised Fund (DAF)? That way, your legacy will continue on in your family as they can then donate this remainder as they see fit.

That is a lot of verbiage. Best guess: you will hear a lot more about this strategy, as the stretch IRA is on the chopping block in Congress in 2019. If your heirs lose the ability to stretch inherited IRAs, they will rapidly owe massive taxes during their peak income years.

The above strategy gives them a tax-free bolus of money from life insurance. In addition, they get a taxable income for 20 or more years from the CRUT. And in the end, the money goes to their DAF or another charity of your choice.

Update for the SECURE Act

With the Secure Act came the end of the Stretch IRA. Is that a big deal? How does a 10-year stretch compare to the stretch IRA.

What are some alternatives to the stretch? 

Conclusion: Best Way to leave money to your Heirs?

So, what is the best way to leave money to heirs?

My advice: convert to Roth if it makes sense from a tax perspective. Roth conversions are amazingly powerful and have many indications.

Leave brokerage accounts at death for a step-up in basis. 

And watch out when leaving IRAs and other qualified accounts, as only death and taxes are certain in this life and the next.

Finally, make sure you have your beneficiary form correctly filled out to optimize disclaimer estate planning.  This is the most flexible and efficient way to pass on your pre-tax retirement accounts.





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  1. New information from IRS is saying inherited pretax accounts must be withdrawn within 10 years true but must be annual withdrawals with balance by year 10

  2. Clearly I need more help with my will. Who do you recommend? I believe there is an organization of people that specializes in estate planning.

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