Shielding Your Heirs: The Expert Guide to a Tax-Free Inheritance

Dear Wealth Wise: How can I put my RMDs and cash savings back to work so I can leave a tax-free inheritance for my adult kids? — None For Uncle Sam

Dear None for Uncle Sam: In the coming years, the Great Wealth Transfer is expected to produce trillions of dollars in inheritance. But that doesn’t mean all wealth holders are planning for that transition mindfully.

Here, our reader wants to know how they can leave their children an inheritance the IRS won’t take a piece of. And while leaving a 100% tax-free inheritance may be challenging, people in this situation can still use several strategies. Here’s what the experts suggest.

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Do a Roth conversion

If you have the bulk of your assets in a traditional IRA, passing that account to your heirs could put them in a tricky spot.

As Eric Croak, CFP and President of Croak Capital, explains, when you have grown children who inherit a traditional IRA, they only get 10 years to empty the account. But adult children often end up withdrawing those funds during their peak earning years, subjecting themselves to high tax rates.

"This seems like an unappealing tax consequence, especially during their highest earning years as the 32% tax bracket begins at $201,775 for a single filer," Croak says.

That’s why Croak recommends Roth conversions, which you can do even if you’re already on the hook for required minimum distributions (RMDs). If your children inherit a Roth IRA, they’ll still be subject to the 10-year rule. But there are a few key differences.

First, says Croak, "no distributions are mandatory during those 10 years," whereas with a traditional IRA, your adult children generally have to take RMDs annually if you, the account holder, are old enough to be subject to them.

Perhaps the biggest benefit of inheriting a Roth IRA is receiving all distributions tax-free, Croak explains.

If you’re going to do a Roth conversion, it’s important to get your timing right, Croak says.

"First, take the RMD for the year since an RMD itself cannot be converted," he explains. "Then convert additional amounts of pre-tax savings and pay taxes now."

Use your RMDs to buy permanent life insurance

If you’re on the hook for RMDs, Croak says another option is to use that money to purchase a permanent life insurance policy on which your adult children are designated as beneficiaries.

"The RMD will be subject to tax when distributed as always, but the after-tax dollars can purchase a death benefit that will be generally income-tax-free to the beneficiary," Croak explains.

However, he cautions, this strategy "makes sense only if you are insurable at a reasonable cost."

Lean on a taxable brokerage account

It’s common for retirees to favor tax-advantaged accounts like IRAs in the course of building and holding their wealth. But if you’re focused on leaving an inheritance, Croak says, then it pays to lean on a taxable brokerage account in addition to or instead of a permanent life policy. So as you take your RMDs, reinvest them strategically.

"Any cash beyond the premiums should reside in a brokerage account rather than a savings account since appreciated stock can receive a stepped-up basis at death, while the interest income on cash would be subject to tax at your highest marginal tax rate," Croak says.

Consider cash gifts

If you'd like to start gifting while you're alive, one simple option is an annual gift. The annual gift tax exclusion in 2026 is $19,000 per recipient (couples can double this to $38,000 per recipient).

Before you give your kids the money while you are still alive, ask yourself three key questions: Do they really need the money now? Can you afford it? And will this be a gift to one child, or all of your heirs?

Be strategic with who inherits which accounts

Leaving a Roth IRA as an inheritance is a true gift. But if your balance is large, doing a full Roth conversion may not make sense from a tax perspective.

In the course of sparing your kids a tax bill, you don’t want to drive yourself into an unreasonably high tax bracket. Plus, large Roth conversions could push you into IRMAA territory, resulting in exorbitant Medicare premium costs.

Given all of that, Will Allen, founder and financial adviser at Sentara Capital, says that your tax bracket coupled with your children’s tax brackets should drive a lot of the math.

"A $600,000 IRA drained over 10 years on top of a 55-year-old's salary can come out at 32% plus state tax," Allen says. "Converting at 24% now to avoid that is a wise move."

That said, if you’re expecting to pass away relatively soon and your children, based on their incomes, may not creep into higher tax brackets for quite some time, a Roth conversion may not make sense at all. If your children can empty a traditional IRA in 10 years and do so at a 12% or 22% tax rate, it doesn’t pay for you to convert at 24%.

You’ll need to look at the math from every angle before making Roth conversions a core part of your inheritance strategy. And if you only do a partial conversion, Allen says, "Split the beneficiary designations by bracket instead of leaving everything equally. Roth and taxable to the high earner, traditional IRA to the lowest earner."

Know which accounts not to leave

If your goal is to leave a tax-free inheritance, there’s one account you should steer clear of — a health savings account, or HSA, says Jordan Smyth, CFA, president and senior wealth adviser at Glassy Mountain Advisors.

Although HSAs are often touted for their triple tax advantage, that benefit effectively disappears when an adult child inherits one.

"Don’t leave an HSA to your children," Smyth says. "The inherited balance would be taxable to any non-spouse heir in the first year. Spend that money and leave them a Roth IRA instead."

State taxes and capital gains may still apply

These are tried-and-true ways to avoid income tax. However, state inheritance taxes or federal estate taxes could still apply depending on the estate's size and the state you live in.

Read More

• We Asked 5,000 Americans About Inheritance and the Great Wealth Transfer. Here's What We Learned
• How to Talk to Your Adult Kids About Their Inheritance
• Why So Many Families Are Unprepared for the Great Wealth Transfer — and What You Can Do About It
• Should We Bankroll Our Son's $180K Law School Tuition Even Though We're Retired?
• 'Subsidized Adulting': Can You Afford to Help Your Children Financially?