What Do I Leave My Kids?

family I have found that folks either entering retirement or currently in retirement are primarily concerned with making sure they have enough money to last until they die.  Usually, leaving an inheritance is an afterthought.  But once I explain to someone that you do not need to lose in order to gain; that actively managed portfolios can and do get out of the market before times of significant loss, the fear of running out of money is alleviated.  This peace of mind allows folks to implement legacy-planning strategies to help generations to come.  Sound logical?
So recently, I had some new clients (let’s call them Dan and Anne) in my office.  They believe in my philosophy that we do not need to lose in order to gain. Dan wanted to know how to plan so that they will have enough money to be able to leave some to their children.  Dan and Anne are fortunate to have pension income and so I explained that it is possible to optimize any potential gift to one’s heirs by strategically spending down certain assets, rather than others, and by constantly monitoring potential tax liabilities.
In my opinion, taxes are a significant issue to consider because taxes have no place to go but up, and here, not all asset classes are created equal. Generally, in order to maximize legacies, we must distinguish between taxable assets, tax-deferred assets and tax-free assets and we must consider the pros and cons of expending each kind.
Now, back to Dan and Anne. First, let’s look at their tax-free assets, which consist of their Roth IRAs. I explained to them that because they already paid income taxes on the money contributed to their Roth IRAs, all of their withdrawals are taken out tax-free. Ideally, in their current situation, these funds are the last to be used because neither they nor their beneficiaries pay tax on the account upon distribution. I explained that while neither of them need to take any lifetime Required Minimum Distributions (RMD) from their Roths, their beneficiaries will be required to take distributions upon inheritance, but the distributions will be tax-free to them, which is extremely powerful. I also explained to Dan and Anne that while there are situations when pulling money from a Roth account can be used to keep a taxpayer from crossing a threshold into a higher tax bracket, this was not the case in their situation. 
Next, let’s discuss Dan and Anne’s taxable assets, which consist of their non-retirement holdings.  These assets can receive a step up in basis treatment at death. When sold by a person who inherits such an asset, they are taxed at their value at inheritance rather than their lower purchase value, and that can mean a lower capital gains tax bill. I used this example.  Upon inheritance, Dan and Anne’s kids will receive securities with a basis equal to fair market value as of the date of death. What this means is that the capital gains tax is avoided on any unrealized gains. So, let’s assume Dan and Anne together own $50,000 in equities that they bought for $5,000. If they sell the equities before they die, they will have to pay tax on the $45,000 gain, or $6,750 (they currently pay a 15 percent long term capital gains rate), leaving $43,250 from the sale. If, on the other hand, Dan and Anne leave the equities to their kids, the basis would now step up to $50,000 so if their kids decide to sell when the market value is $50,000, they pay no capital gains tax, and in effect receive the full value of the assets. That’s why I suggested to Dan and Anne that it might be best to tap market-value assets first, like money in checking accounts, CDs, or money market funds where there’s no tax benefit. Spend these first.
Last are Dan and Anne’s tax-deferred assets. Generally, tax-deferred assets, such as traditional IRAs, are worth holding onto. Because earnings are not taxed every year, the investment compounds untaxed, significantly enhancing its long-term growth potential. Nevertheless, there are some qualifications to this strategy. Everyone must begin taking RMDs from their IRAs once they turn 70½ years old. In Dan’s case, because he has other income sources but must take his RMD, I recommended, if possible, he limit withdrawals to the minimum. However, given the new, Net Investment Income Tax (NIIT, commonly known as the Medicare surcharge), I told Dan that it is also important to take enough of a distribution now, so that future distributions don’t push him to a higher tax bracket. (Since withdrawals from qualified accounts like 401(k)s and IRAs may increase modified adjusted gross income above the threshold that triggers NIIT, it sometimes makes sense to begin larger withdrawals earlier when people are generally in higher tax brackets anyway, in order to make sure withdrawals down the road don’t keep someone at a higher bracket longer than needed, as annual income decreases.)
A second reason to withdraw money from a tax-deferred account, rather than to leave it to a beneficiary, is to keep the withdrawal taxed at a lower bracket, if the beneficiary is in a higher tax bracket.  Anyone withdrawing money from a retirement account must pay ordinary income tax on all funds withdrawn, including a beneficiary who receives a retirement account upon the owner’s death. It might be better for a retiree in a low tax bracket to remove money from a retirement account rather than leave it to a working child who is in a higher tax bracket.
I know it sounds complicated, but the tax treatment of assets can have a big impact on the size of any inheritance passed to heirs.  Make sure you seek financial advice from professionals who specialize in and understand the importance of advanced tax planning to help you secure a solid financial plan.
Be vigilant and stay alert, because you deserve more!
Photo Courtesy of Microsoft