In last week’s column, we talked about the complexity and confusion around inherited IRA distributions. In response to that column, a number of people expressed concern about how inheriting an IRA would affect their beneficiaries. If you are thinking of leaving your IRA to children or grandchildren, here are some things you may want to consider.
Over the past several years, Congress has systematically closed one tax break after another. One of the best tax breaks remaining is the step-up in cost basis that estates experience when the estate’s owner dies. This step-up in basis can wipe away years of accumulated capital gains in one fell swoop.
Most types of assets are eligible for a step-up in basis upon the owner’s death. Eligible assets typically include:
- Real estate, such as a house, land, or commercial property.
- Securities, including stocks, bonds, mutual funds, exchange-traded funds and other securities held in taxable investment accounts.
- Shares in privately held businesses or partnerships.
- Some personal property may also qualify for a step-up in basis, such as valuable artwork, collectibles, jewelry, and other items.
Notably missing from this list are IRAs, 401(k)s, and other self-directed retirement accounts. If you leave a traditional IRA or 401(k) to your heirs, you are bequeathing both an asset and a tax liability. This is a significant issue across the entire American wealth management landscape. According to recent estimates by the Investment Company Institute, Americans hold more than $25 trillion in personally directed retirement accounts such as IRAs and 401(k) plans and most are held, not surprisingly, by individuals 55 years of age or older.
In the past, the tax impact of inheriting an IRA was lessened by allowing beneficiaries to stretch their distributions over their remaining lifetimes. However, as we discussed last week, recent changes require most beneficiaries to completely withdraw inherited IRA assets within ten years of the decedent’s death. The ten-year withdrawal window means that withdrawals will come sooner and often at higher tax rates than before. An example will help illustrate what I mean.
Under the old rules, a 40-year-old beneficiary who inherits a $1 million IRA could have stretched withdrawals from the inherited IRA over her remaining lifetime. Without accounting for market growth, her withdrawals during the first ten years would have been about $22,000 per year, or roughly 22 percent of the inherited value. Under the new rules, she will have to take the entire $1 million in the first ten years, more than four times the previous amount. For many heirs, this additional income will hit during their peak earning years.
So, what can IRA holders do to help lessen the tax burden on their beneficiaries? One successful strategy is to start a regular program of Roth IRA conversions. The analysis for a Roth conversion is primarily a comparison of current tax rates versus expected future tax rates. When it comes to inherited IRAs, the proper analysis would be for the IRA holder to compare his tax bracket with the tax bracket of his heirs including the distribution they would expect to take from the inherited IRA.
For example, let’s suppose a married-filing-jointly IRA holder has annual income, including the RMD from his IRA, of $85,000 in 2023 putting him in the 12% federal tax bracket. Suppose further that his single daughter earns $96,000 year, putting her in the 24% federal tax bracket. If the daughter were to inherit the IRA right now, her withdrawals would be taxed at the 24% marginal tax rate. In this case, the IRA holder would be justified in doing up to $105,000 in Roth conversions because that is the amount that would put him in the 24% tax bracket. In this situation, you can think of the Roth conversion as prepaying taxes on behalf of the heir.
You can also be tax efficient by carefully considering who receives what in your estate plan. When possible, leave taxable assets to heirs who pay taxes and tax-deferred assets to those who do not. Tax-paying heirs will get the tax protection afforded by a step-up in cost basis, while tax-exempt heirs, like your favorite charity, will receive the IRA distributions tax-free.
Please see important disclosure information here.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.