Many parents fail to get their financial affairs in order, neglecting to take care of such things as wills, living wills and powers of attorney. But even those who think they’ve covered all of their bases often leave one of the most important tasks undone: They fail to talk to their adult children about the money they’ll be leaving them someday.
For many, I’ve found, it’s because it’s a private topic — and an uncomfortable one. But passing an estate on in the most efficient manner possible is a tough thing to manage. Especially if you haven’t had at least a general conversation about where your money is, how to get to it and — just as critical — how to minimize the taxes on various types of investments when they’re inherited. Therein lies the potential issues, because not all assets are inherited the same and, therefore, are not taxed the same.
Unfortunately, I’ve found many parents don’t know the answers themselves to be able to discuss with their kids. It may be necessary to educate yourself before you can share this information with your family. Here are some things you and your kids should know about.
1. What are the tax ramifications of inherited IRAs?
Your children may not be aware that if they inherit your IRA, they’ll be paying taxes on withdrawals, just as you were. Your beneficiaries can choose a “stretch” IRA option, leaving the funds in the IRA for as long as possible while taking required minimum distributions based on their life expectancy (their RMDs would begin the year after your death, not by age 70½), or they must liquidate the account within five years.
The stretch option is smart, but try telling that to a kid who sees the money as a one-time windfall that could pay for a new car or even a house. At the very least, talk about the potentially devastating tax consequences of taking a lump sum: Beneficiaries could lose up to 40% or more of the account.
2. What about an IRA rollover?
A non-spouse beneficiary can’t roll your IRA money directly into his or her own IRA or 401(k). Doing so could trigger a major tax bill because now the whole amount will become taxable income — and there’s no do-over. Be sure your IRA custodian will administer inherited IRAs for your children and will automatically take care of any required minimum distributions so your loved ones don’t have to worry about it, because if they don’t take the required amount, the tax penalty is 50% of whatever they were supposed to take, plus whatever their ordinary income tax rate would be on that amount. (Distributions from an inherited Roth IRA have similar rules but are tax-free unless the account was established less than five years before.)
3. What tax strings can come with an inherited annuity?
Keep in mind that other non-retirement tax-deferred assets, such as annuities, also can come with a tax time bomb when they are inherited. The insurance company will issue a Form 1099 for any untaxed growth to your child, and that amount must be included as gross income when they file their taxes.
That might be OK, if you’ve discussed it ahead of time and your child is in a lower tax bracket than you are. But I’ve seen more than one beneficiary who considered it an unpleasant and unwelcome surprise.
4. How does a step-up in basis work?
You and your kids also should understand the term “step-up in basis” and how it will affect some non-retirement account appreciated assets they inherit, including stocks, bonds and real estate. The value of the asset on the day you die will be your heir’s cost basis, not what you paid for it.
So, for example, if you paid $300,000 for your vacation home, but it’s worth $500,000 when you die, that becomes the cost basis for your heirs. If your child sells the home for more than $500,000 in the future, any capital gains tax will be calculated based on the “stepped-up basis” of $500,000, not your original basis of $300,000.
5. Who has the financial details that can help?
Think about setting up an appointment for your beneficiaries to meet your adviser with you there. If everyone is spread out in various locations, maybe a video or phone conference would work. If that isn’t possible, at a minimum be sure to leave contact information with everyone, so they can reach each other after your death. Even if you shared the basics with your children, you’ll want them to have this person on their side to advise them as soon as possible.
I’ve seen parents who have done a pretty good job of talking to their kids about other money matters — budgeting, saving, building good credit, etc. — but drop the ball completely when it comes to preparing them for an inheritance.
Matt Hausman is the founder and president of Old Security Trust Corp. and Old Security Group, a Registered Investment Advisory Firm. He focuses on helping clients recognize when they are unknowingly and unnecessarily transferring away their wealth, and believes in helping empower consumers through effective information on financial strategies. Matt has passed the Series 65 exam and holds life, health and title licenses in multiple states.
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