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
- Resist the Taboo: Talk to Your Kids About Family Wealth
- To Protect Your Kids, Consider These Estate Planning Steps
- Four Ways to Give Money Tax-Free to Your Kids When You Die
- IRS Quietly Changed the Rules on Your Children’s Inheritance
- How to Optimize Taxes When You Tap Your Retirement Accounts
-
Bullish IPO: Should You Buy BLSH Stock?Wall Street is buzzing about the Bullish IPO, with the Peter Thiel-backed crypto company set to start trading today, August 13, under the ticker "BLSH."
-
How the 2025 Child Tax Credit Rules Impact Single ParentsTax Credits New changes to family tax credits, like the Child Tax Credit, will impact the eligibility of some households.
-
How to Build Your Financial Legacy Three Piggy Banks at a TimeA wealth adviser shares a childhood saving technique that taught him lessons of stewardship, generosity and responsibility and helped him answer the question we all need to answer to define our lives by impact rather than greed: 'What is this all for?'
-
Which of These Four Withdrawal Strategies Is Right for You?Your retirement savings may need to last 30 years or more, so don't pick a withdrawal strategy without considering all the options. Here are four to explore.
-
DST Exit Strategies: An Expert Guide to What Happens When the Trust SellsUnderstanding the endgame: How Delaware statutory trust dispositions work, what investors can expect and why the exit is probably more important than the entrance.
-
Think Selling Your Home 'As Is' Means You'll Have No Worries? Think AgainThere are significant risks and legal obligations involved in selling a home 'as is' and by yourself, without a real estate agent.
-
What the OBBB Means for Social Security Taxes and Your Retirement: A Wealth Adviser's GuideFor Americans in lower- and middle-income tax brackets, the enhanced deduction for older people reduces taxable income, shielding most of their Social Security benefits from being taxed.
-
Financial Planner vs Investment Manager: Who's the Better Value for You?When markets are shaky, who do you trust with your money? A recent study provides useful insights into the value that different financial professionals offer.
-
I'm a Financial Adviser: This Is How You Could Be Leaving Six Figures in Social Security on the TableClaiming Social Security is about more than filing paperwork and expecting a check. When you do it and how you do it have huge financial implications that last the rest of your life.
-
The Big Pause: Why Are So Many Americans Afraid to Retire?While new research sheds light on Americans' growing reluctance to quit work in later life, can anything be done to help those with the retirement jitters?
