We talk a lot about saving for retirement and managing income once you get there, but it’s just as important to plan for the steps after that: leaving an inheritance, and hopefully setting the stage for generational wealth. The same factor that makes it difficult to save enough for retirement comes into play once you pass your wealth to your loved ones. Taxes are simply unavoidable, and there’s a great risk that what you leave to your spouse, children, or grandchildren will be significantly diminished once Uncle Sam takes his cut.
People often say that one of the best gifts you can leave to your loved ones is pre-paying your funeral expenses. What if you could do the same for the taxes associated with their inheritance? Let’s look at the problems with traditional strategies, and then explore better options for leaving a tax-efficient inheritance.
The Problem With Inherited Retirement Accounts
Retirees and financial planners used to make the most of a handy little feature called the “stretch IRA.” You could name your spouse, kids, or grandkids as the beneficiary for your IRA, and they could spread out their RMDs for the duration of their life expectancy. That way, there was no lump sum impacting their tax bracket, and they could keep as much of the funds as possible in the account for as long as possible, encouraging continued growth.
However, the option for a stretch IRA was eliminated with the SECURE Act in 2020. Now, non-spousal beneficiaries of inherited IRAs have ten years to withdraw the full amount of the inherited retirement account. Talk about a ticking tax bomb! Without the flexibility to spread out distributions, your kids or grandkids will be forced into a higher tax bracket, losing a larger cut of what you left to them.
“Well,” you think, “that won’t affect me because my spouse is named as my beneficiary.” Leaving tax-deferred savings to a spouse can actually cost them more than it helps them. The marginal tax rate for single filers is higher than for those married filing jointly. If your spouse inherits your IRA, adding it to their own means their RMDs will increase proportionately. Their tax liability has already increased with the change to their filing status, and now their tax bracket will likely increase as well. This can also cause a spike in their Medicare costs, which increases the likelihood that they’ll now have to withdraw more each month just to stay afloat. And what happens to that IRA if you should outlive your partner?
Another problem to be aware of is the year-of-death RMDs. If you have started taking RMDs, your beneficiaries will have to figure out if you already took those distributions for the year of your death, and the clock is ticking. They have until December 31st to figure out whether or not you took the RMD, and then take it themselves, otherwise, they’ll incur the 25% excise tax on the amount that was missed. If you pass late in the year, you can imagine the immense amount of stress this adds to your loved ones during a season that is already difficult.
Take Taxes Off the Table
There is a surprisingly simple solution to the issues that come with inherited retirement accounts: prepay the taxes. It isn’t quite as easy as writing a check to the IRS, but there are three different ways you can do this:
Option One: Consider a Roth Conversion
We’ve talked at length about what a Roth conversion entails and how to know if it’s right for you (you can read more here), but with this option, you are turning tax-deferred savings into tax-free assets. When rolling a traditional IRA or 401(k) over into a Roth, you will pay all of the taxes at front. Yes, it will sting a bit, but a financial advisor and tax planner can help you time the rollover so it costs as little in taxes as possible. Keep in mind that you don’t have to do it all at once! You can gradually roll over your accounts and spread out the tax bill.
Option Two: Opt for Modern Life Insurance™
Did you know that you can leave your beneficiaries with a tax-free lump sum in the form of a death benefit, thanks to Modern Life Insurance™ products? This creates a valuable opportunity for the surviving spouse, who still has bills to pay with half of their former income and a higher tax rate. Now, let’s say your spouse passes before you. You can keep the policy for your kids or grandkids, or use the policy for your own long-term care needs. With the right plan structure, you can even exercise a 100% return of premium benefit. Regardless of who receives the benefit, it will be tax-free (minus any interest), since the policy was purchased with post-tax dollars.
Option Three: Invest in a Non-Qualified Fixed Indexed Annuity
Annuities come in two packages corresponding to their tax treatment: qualified annuities are funded with pre-tax dollars, so you’ll pay taxes when you withdraw, whereas non-qualified annuities are funded with post-tax dollars. With many FIAs, you can purchase an optional rider to enhance the death benefit left to your beneficiaries by either offering enhanced payout options or guaranteeing income for life. That’s a huge improvement on a ten-year countdown for withdrawals! As long as the plan was purchased with post-tax dollars, your beneficiary will only own taxes on the earnings of the benefit; the principal amount will be passed to them tax-free.
Customizing Your Strategy
The best part is that you can combine all of these strategies and kill multiple birds with one multi-faceted stone: protect your assets during your lifetime, mitigate the impact of market fluctuations on your retirement savings, create income flexibility during retirement, and leave an inheritance that doesn’t create a tax burden.
It’s important to work with a financial team experienced in the intricacies of life insurance and annuities, as well as long-term tax and legacy planning. With over 25 years of experience, Parady Financial Group fits the bill and is ready to help you free your loved ones from taxes on inherited retirement accounts. Are you ready to plan a better future for the people who mean most to you? Start your journey here.
Sources
https://www.bankrate.com/retirement/inherited-ira-rules/#:~:text=An%20inherited%20IRA%20may%20be%20taxable%2C%20depending%20on%20the%20type,subject%20to%20ordinary%20income%20taxes. https://www.protective.com/learn/retirement/do-annuities-have-beneficiaries
