Don't Leave Your Heirs an IRA Tax Bomb

Choosing to name your children as beneficiaries over your IRA is a nice gesture. But without proper planning, it can become a huge tax burden that could result in the IRS getting more of their inheritance money than you intended. So, what can you do — as a parent — to help minimize the tax bill?

First and foremost, it’s worth noting that you can’t get around paying taxes on a traditional IRA. Whether you’re the initial owner or a beneficiary, the IRS wants its cut. It seems simple enough, but what you may not realize is that the beneficiaries you name on your IRA will be taxed based on their tax bracket, not yours. Generally speaking, your children will likely be in a higher tax bracket than you — especially if you’re retired and they’re still working.

To give you more perspective, imagine you’re retired and currently fall into the lowest tax bracket possible. Note the lowest tax bracket in 2024 is 10%, which applies to single filers making up to $11,600 or joint filers making up to $23,200. Let’s say you decide to name your eldest child, Rob, as a beneficiary of your traditional IRA, which is worth $600,000. Rob, who is single, works as a lawyer, making $115,000 a year with a tax rate of 24%.

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If you were to die suddenly, that $600,000 would be taxed at 24% because that’s the tax bracket Rob falls into. In other words, because your son falls into a higher income tax bracket, his inheritance from your IRA is taxed at more than double your rate. Furthermore, he’ll likely only have 10 years to draw down that account due to the IRS’ 10-year rule.

So, what steps can you take now to help ease the tax burden for your heirs?

Roll funds into a Roth IRA

You could convert your traditional IRA to a Roth. You will have to pay taxes on the amount that you convert at your ordinary income tax rate, but withdrawals will be completely tax-free from then on out— for you and your heirs. So, even though Rob is in the 24% tax bracket, he would pay 0% in taxes on his inherited Roth IRA.

Roth conversions can have wide-ranging effects on things like Medicare premiums and the taxes you pay on your Social Security, so it’s important to be strategic about when you make them and how much you convert at a time. There are several windows of opportunity for Roth conversions, including the years when you’re between retirement and the age at which you must start taking required minimum distributions. But with so many variables to account for, it’s a good idea to consult with a financial adviser to make a plan.

Avoid dividing accounts equally among children in different tax brackets

If Roth conversions don’t make sense in your situation, or if you convert only a portion of your traditional IRA, chances are you may still have a significant amount in your traditional IRA to pass down. So, what else can you do to help limit the taxes your heirs will pay?

Since children in higher tax brackets will ultimately pay more in taxes on the inherited amount from traditional IRAs, consider distributing more funds from your IRA to your children in the lower bracket to minimize the tax burden. While you think you’re being fair in dividing it equally, your children won’t end up with the same amount post taxes due to varying income tax brackets. So, give Johnny — a teacher in the 12% tax bracket — your IRA and give Rob — a lawyer in the 24% tax bracket — your money market account, which has less far tax consequences.

Prioritize drawing money from your IRA over other income streams

It may not seem like it, but making this income source a priority in your early retirement years can be a huge benefit to your heirs. Drawing from this account first is a tax-smart strategy that will not only reduce the taxable amount for your heirs, but it will also help you minimize your tax bill.

Meet with an adviser

If you’re planning to leave an IRA to your children, meet with a financial adviser to determine how to handle those funds. You could put them in a CD, an annuity or invest in securities. A professional can help you talk through these options in more detail. Regardless of which option you choose, the money should still be growing, just in a different vehicle.

Passing wealth on to your children or other loved ones is a great act of kindness. Don’t let a lack of planning turn your gift into more of a burden for your heirs. Do some research on the best ways to repurpose that money and set up an appointment with a professional. They can help you talk through your options, minimizing the bill you may pay.

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