Planning the Next Life: How to Leave Money to Your Heirs
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As I am fast approaching the financial goals I set up for myself years ago, when I first decided to embark on my financial path to wealth, my thoughts have started turning towards the ability to leave a financial legacy for my heir(s).
As a parent there is nothing I wish more than to see my daughter succeed on her own, based on her own merits.
However, I also feel that if I can somehow help elevate her lifestyle several orders or more with financial help when I am no longer around, it too would bring me great pleasure.
In order to achieve this mission, I knew I would have to master the Decumulation phase of the financial life cycle, so that I can maximize transfer of wealth to my intended beneficiaries without Uncle Sam and the court system lining their pockets instead.
Most individuals think the accumulation phase of wealth is the toughest.
Sadly, they are mistaken.
The decumulation phase is far more trickier to navigate as there are so many more variables out there (life expectancy for you or your spouse, the unknown sequence of return risk present at time of retirement, future tax law changes, inflation concerns, etc.).
All this without the safety net of a steady W2 income.
David, an infectious disease specialist, is the blogger and brainchild behind FI Physician, a registered investment advisory.
He has an incredible analytic mind and has a knack for making tough concepts easy to conceptualize with the aid of amazing graphics.
I therefore reached out to David and asked if he would do me the honor of a submission on my platform and speak on the difficult subject of Decumulation and how to approach it.
He graciously accepted.
XRAYVSN challenged me to answer a question about de-accumulation.
“What would be the differences in drawdown approach if:
- you want to leave heirs the best tax advantaged inherited money vs
- maximize the money you receive during lifetime (goal of leaving $0 at death).”
This post is part one of a two-part series to answer his question.
Here, we will tackle leaving your heirs the best tax advantaged money.
The next post will address strategies to give your money away to charities and have $0 at death.
Which Accounts Should You Leave to Your Children?
Thinking briefly about tax implications of assets, you have three main different types of accounts.
These accounts are Never Taxable, Sometimes Taxable, and Always Taxable.
Certain accounts are more beneficial to leave to your heirs than others.
An example of a “Never Taxable” account is a Roth IRA.
Roth IRAs are the best accounts to leave to your heirs as they will never pay taxes on this inheritance.
In addition, these accounts continue to grow tax-free during their life.
Required Minimum Distributions (RMDs) are mandatory when these accounts are inherited, but current law allows your heir to take RMDs over the heir’s remaining life expectancy (See Appendix B).
[This strategy has been referred to as using a “stretch IRA.”]
Therefore, if your kids are young, these accounts will continue to grow over time and always pay out tax free.
“Sometimes Taxable” accounts are brokerage and savings accounts.
When invested, these accounts get a “step-up” in basis when you die.
Say you bought VTSAX at $10 and when you die it is worth $200.
If you sold the stock before death, you would have to pay capital gains taxes on $190.
If gifted, the basis transfers with the gift, again resulting in capital gains taxes.
But your heirs get a full step-up in basis of $200 at your death.
They can then sell at $200 without paying capital gains.
If you have appreciated assets in brokerage accounts, consider leaving them there until your death, rather than giving them away, so you get the step up in value.
There are no RMDs on brokerage accounts, but any future growth is taxable.
These accounts are the trickiest.
“Always Taxable,” or qualified accounts, are your pre-tax retirement accounts.
Whenever you or your heirs take money from these accounts, taxes are owed.
When inherited, Always Taxable accounts are pleasantly called IRD by the IRS: Income in respect to the decedent.
That means you died, but heirs still need to pay taxes.
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 lesson: Don’t title 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 gift 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 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, as long as you 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.
All I Need is a Will, Right?
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 in any other way, consider a living trust.
With this document, you make the trust the 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-titled into the trust.
In some states where probate is particularly expensive or otherwise offensive, living trusts are a smart choice.
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 their remaining lifetime, paying taxes at low rates slowly over time.
This will keep the IRA growing tax-deferred.
Your heir, as they are in low tax brackets, pays only a small amount of taxes year after year on RMDs from the inherited IRA.
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.
Your 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 your 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 the 48% 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 your 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.
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 and other surcharges on Medicare), 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.
“What would be (a) drawdown approach if you want to leave heirs the best tax advantaged inherited money?”
Well, XRAYVSN, I hope I answered your question.
My advice: convert to Roth if it makes sense from a tax perspective.
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.
David Graham, MD is a practicing Infectious Disease Physician and a Registered Investment Advisor in the state of Montana. He blogs at FiPhysician.com
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