(This article originally appeared on MarketWatch.com.)
Many individuals craft their estate plans to distribute assets equally between family members. It’s a simple method designed to treat each person fairly, but it doesn’t always work out that way. What’s the kink? Taxes, of course.
Unless all of your beneficiaries pay income tax at the same marginal rate — which rarely occurs — a lack of incorporating their tax situations into your planning process can muck up your intended legacy in two key ways:
- Your beneficiaries don’t actually end up receiving equal amounts
- More taxes are paid than necessary
I briefly touched on this concept in my last column “How to take the stress out of estate planning,” and want to further illustrate how this common oversight may make you reconsider how to allocate your estate.
Tax Basics of Inherited Assets
Contrary to what you may think, your Individual Retirement Account (IRA) isn’t owned solely by you, even though it’s in only your name. Your IRA is really jointly owned by you and the Internal Revenue Services (IRS) and potentially your state government.
Unless your beneficiaries pay tax at the same rate, a lack of incorporating their situations into planning can muck up your intended legacy.
For a typical person, it’s not uncommon to “own” only 65 percent of an IRA, while the IRS claims the other 35 percent in taxes over time. Unfortunately, the government’s claim on this money never ends. Instead, your beneficiaries inherit this embedded tax liability and are stuck paying the tax bill as distributions occur.
Taxable investment accounts are treated differently than IRAs. With a taxable account, taxes are paid annually on interest and dividends in addition to any realized capital gains. When you pass, the cost basis of the assets is “stepped up” to the fair market value, thereby eliminating any unrealized gains (a huge potential tax benefit). This allows your beneficiaries to inherit the account with no embedded tax liability, unlike the IRA.
When beneficiaries have different income-tax rates, the type of asset they inherit is crucial to maximizing the total inheritance. Consider a married couple with three children: Bob, Jim and Joanne.
Bob is a doctor at the top 39.6 percent marginal tax rate. Joanne is an IT consultant at the 28 percent tax rate. Jim is a teacher at the 15 percent tax rate. The parents have $900,000 in assets ($600,000 in an IRA and $300,000 in a taxable account) and their estate plan directs these assets to be left equally to their three children.
Since the children have vastly different tax situations, however, the inheritance each child actually receives after the “inherited” tax liability is considered (which is the amount actually available to use) is clearly unequal — to the tune of $50,000.
Equal pre-tax inheritance — unequal after taxes
|Tax Rate||Bob – 39.6%||Joanne – 28%||Jim – 15%||Total|
|“Inherited” tax liability on IRA||($79,200)||($56,000)||($30,000)||($165,200)|
Not only did the unequal inheritance (after taxes) not align with the parent’s intent, but a larger “inherited” tax liability was created. In this example, the main cause for the unequal inheritance was the IRA. Remember, the higher a beneficiary’s tax rate, the larger the share Uncle Sam claims, making the IRA a less-than-desirable asset for the beneficiary with the highest income.
Rather than leaving their children an equal distribution, the parents meet with their tax adviser to create a more tax-efficient inheritance strategy. Because of his high tax rate, Bob does not receive any of the IRA. Instead, his inheritance is composed entirely of assets from the taxable account, where he’ll get a much bigger benefit from the “step up” in cost basis than his siblings. Joanne, being in a middle tax bracket, receives a blend of IRA and taxable assets. Jim, being in the lowest tax bracket, receives an inheritance entirely composed of the IRA.
Unequal pre-tax inheritance — equal after taxes
|Tax Rate||Bob – 39.6%||Joanne – 28%||Jim – 15%||Total|
|“Inherited” tax liability on IRA||$0||($83,160)||($45,450)||($128,610)|
What initially appeared to be an unequal pre-tax distribution became almost completely equal after taxes were considered. Not only that, the children as a group inherited $36,590 more than they would have with a strategy that simply divided each account equally.
Planning for an Unequal Distribution
Most estate plans are not designed to be optimized for income taxes. While it may be beneficial to incorporate this type of planning into your estate, it must be balanced with the practical requirements of implementing such a strategy.
Distributing assets unequally is a complex process requiring a high degree of financial knowledge, perpetual review, potential revisions along the way, coordination among involved parties, and the ability to handle potentially difficult communications. Consider the following when planning for your estate:
- Decide how much each beneficiary should receive: Do you want all of your beneficiaries to receive the same amount before or after taxes? If one child receives more than the others (from a pre-tax or after-tax perspective), will that create hostility among your children?
- Make “tax smart” allocations: In general, beneficiaries with higher tax rates often benefit from receiving assets from a taxable account (but not always). Conversely, those with lower tax rates are often better to bear the burden of the “inherited” IRA tax liability. Just remember, in order to maintain a tax-efficient distribution your beneficiary allocations may need to adjust over time as a beneficiary’s tax rate changes.
- Explain any inequalities: Before you pass, be clear with your children about your distribution plan. If one child is going to receive more or less than their siblings, make sure to explain the rationale while you are still alive. If your plan isn’t made clear, it opens the door for bad blood among your kids in the future.
- Fund charitable bequests with retirement accounts: If philanthropy is part of your estate plan, consider funding your charitable intent with IRA assets. Since the tax rate for charities is 0 percent, the income-tax liability related to those accounts can completely disappear when the charity is the beneficiary.
- Lifetime Roth conversions: Depending on your beneficiaries’ tax rates, it may be better for you to incur the taxes on your retirement savings so they are passed on with no tax liability. This can be done by converting your traditional IRA to a Roth IRA during your lifetime. In addition, all future growth of those investments is tax-free to both you and your beneficiaries.
Great income-tax planning incorporates the benefits/costs across multiple generations, but don’t let that focus on limiting taxes get in the way of a happy transition when you pass. Remember, preserving family harmony is of paramount importance. A balance of strategic tax decisions vs. keeping things as simple as possible will help you achieve the right balance of both goals.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax adviser.
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This article is reprinted with permission from MarketWatch.com. © 2015 Dow, Jones & Co., Inc. All Rights Reserved.