Estate planning is a critical aspect of comprehensive financial planning, especially when it comes to ensuring your heirs receive the maximum benefit from your legacy. Among the various components of estate planning, the designation of beneficiaries for individual retirement accounts (IRAs) is a particularly nuanced decision with far-reaching tax implications.
The distinction between Roth IRAs and traditional IRAs (or company retirement plans) is crucial to understand when planning for the future of your heirs. Each type of account is subject to different tax rules upon distribution:
- Roth IRAs. These accounts offer tax-free distributions to beneficiaries, which can be particularly advantageous for heirs who are in higher tax brackets.
- Traditional IRAs and retirement plans. Distributions from these pre-tax accounts are taxed according to the beneficiaries' individual tax rates, which means that the actual amount received after taxes can vary significantly among your heirs.
A one-size-fits-all approach in designating equal percentages to each beneficiary may not be the most effective strategy. Instead, a more tailored approach that considers the unique tax brackets of each beneficiary can lead to a more equitable distribution of your estate.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Impact on after-tax inheritance
Consider a scenario where Clara is 80 years old and looking to maximize the amount that goes to her heirs, subsequently reducing the amount claimed by Uncle Sam at tax time. Ray is a prominent attorney in the highest tax bracket of 37%. Steven earns less money and falls in the 12% federal tax bracket.
Clara has $1 million in a traditional IRA (pre-tax account) and $500,000 in a Roth IRA. Initially, she had split both accounts 50/50 between her two sons. However, leaving more of the tax-free Roth to Ray may make sense because he is the higher-earning beneficiary. More of the traditional IRA could be left to Steven, as he is in a lower tax bracket, and the taxable distributions from the IRA are less impactful. Consider the following:
By adjusting the amount going to each beneficiary, Clara's distribution was more equitable to each child. She also was able to have less of her inheritance lost to taxes. In fact, she was able to give her heirs a total of $62,500 more ($1,317,500 - 1,255,000) than by splitting each account 50/50.
This also works when considering how much to leave a beneficiary from taxable brokerage accounts. Because of how capital gains are taxed, you may be able to leave your heirs more money by adjusting the amount each beneficiary receives based on their tax bracket.
Tax-efficient estate planning
In essence, strategically designating IRA beneficiaries transcends mere asset distribution; it is a testament to the power of informed financial planning and the profound impact of tax considerations on inheritance. This example illuminates a path for families that can significantly enhance the value of their legacy for their heirs.
By eschewing the traditional equal-split approach in favor of a model that aligns with each beneficiary's unique tax situation, individuals can ensure that their heirs are positioned to receive the maximum possible benefit from their inheritance. This method not only honors the benefactor's intent to provide for their loved ones but does so in a manner that is both tax-efficient and equitable, allowing for a legacy that is felt more deeply and preserved more completely.
The case of Clara and her sons serves as a compelling illustration of how adjusting beneficiary designations to account for different income levels and associated tax brackets can result in a more favorable after-tax outcome. Such strategic adjustments, while requiring careful consideration and possibly the guidance of a certified financial planner, can significantly reduce the tax burden on the estate. This allows a greater portion of one's life savings to reach the intended recipients — fully embodying the true spirit of a given legacy.
Investment advisory services offered through Osaic Advisory Services, LLC (Osaic Advisory), a registered investment advisor. Osaic Advisory is separately owned and other entities and/or marketing names, products or services referenced here are independent of Osaic Advisory.
Related Content
-
Stock Market Today: Stocks Waver on Resilient Employment DataA private reading on payrolls had markets rethinking rate-cut bets just days ahead of the monthly jobs report.
-
Lamb Weston Stock Gains After Earnings Beat, Layoff NewsLamb Weston stock is higher after the french fry maker reported earnings and unveiled a restructuring plan that includes job cuts. Here's what you need to know.
-
This Trust Strategy Can Reduce Your Taxes Big-TimeUpstream basis planning can help younger wealthy people pay less taxes on highly appreciated assets if they appoint an aging relative as a trust beneficiary.
-
Three Major Estate Plan Mistakes to AvoidA complete and up-to-date estate plan can help ease your loved ones' worries and make things easier for them after you pass.
-
Which Type of Power of Attorney Is Right for You?Durable or limited? How about springing or military? There are many more kinds of POAs than just medical or financial.
-
How Employers Can Ensure They're Paying All Employees Fairly'Equal pay for equal work' has been the law since 1963, but pay gaps because of gender, race and other characteristics persist. How does a company get it right?
-
Do You Know How Much You've Saved in Your 401(k)?And are you sure you're enrolled in one? A surprising number of workers don't know where they stand with their company's retirement plan. Time to find out.
-
Riches vs Wealth: A Cautionary Tale From 'The Hobbit'The story of dwarven king Thorin Oakenshield in J.R.R. Tolkien's classic novel perfectly illustrates how the relentless pursuit of wealth can undermine the fulfilling experience of true riches.
-
Gen X: We Need to Talk About Your RetirementJuggling kids, aging parents and work? No wonder you don't want to talk about your own retirement. But there are four key areas you should be discussing now.
-
How Much Do You Need for a Comfortable Retirement?What you need to be comfortable in retirement won't be the same as what your neighbor might need. Here's a scenario in which $1 million might be enough.
