An Individual Retirement Account, or IRA, is a powerful savings tool. You can deduct your contributions on your current tax return and watch those funds grow tax-deferred. At some point you’ll be required to begin taking taxable distributions, ideally after retirement when your tax rate may be lower. But what happens to your IRAs when you die?
You might assume your IRA simply passes to your beneficiaries. What’s easy to forget is that there’s an additional beneficiary you didn’t list on your forms: the IRS. Think of it as a beneficiary imposed upon you and to whom you’d like to give as little as possible.
In my practice, I often see IRAs transition into Inherited IRAs as their owners pass away where little thought was given to tax planning, burdening the heirs with large tax bills.
How IRAs Typically Pass
Upon the owner’s death, an IRA most often passes first to a spouse, who is usually named the primary beneficiary. Spouses can receive this transfer tax-free. That’s the good news.
The bad news is that if the spouse already has an IRA, the combined balance can create a bigger tax burden to the spouse when they are forced to take large required minimum distributions (RMDs) that they may not even need.
When the surviving spouse dies, those assets usually pass to the next set of beneficiaries, usually the children. And that creates an additional set of challenges.
Children As Beneficiaries
By the time children inherit IRAs, they’re often in their peak earning years and therefore in their highest tax brackets. Inheriting a large IRA may be a “good problem to have,” but the IRS’s slice grows accordingly. And unlike spouses, children and other “non-eligible” designated beneficiaries must withdraw all funds within ten years under the SECURE Act’s 10-Year Rule.
The rules here are also complex, but one way or another all those withdrawals will be taxed as ordinary income. This means distributions could not only be taxed at the child’s already high rate but may even push them into a higher bracket.
Minimizing Taxes
Some owners ignore the issue, reasoning that their children are receiving “found money” and can handle the taxes later. But thoughtful planning can greatly improve their after-tax outcomes.
1. Consider The Ultimate Beneficiaries
If your children have children of their own, some funds may ultimately be intended for them. In that case, naming grandchildren as partial primary beneficiaries may reduce taxes—so long as the grandchildren are old enough to avoid the “kiddie tax” that subjects minors’ IRA distributions to their parents’ tax rate. But naming young grandchildren can sometimes make sense, since by the time they inherit, they may be already supporting themselves at lower tax rates than their parents. And if they aren’t, they may be able to manage distributions efficiently if they are close enough to getting their first jobs, by which time their tax rates are likely lower than their parents’.
2. Start Converting Your IRA Into A Roth IRA
Another strategy is to gradually convert a traditional IRA into a Roth IRA. This triggers taxes for the owner, but if done after retirement (when tax rates are presumably lower) it can significantly reduce the burden for children inheriting at higher rates. While it requires the owner to pay the tax bill upfront, children could potentially assist by gifting money to their parents (within gift tax limits) to offset those taxes. This is a preemptive way for the beneficiaries to lock taxes at a lower rate. This approach demands careful coordination, but can create substantial savings.
3. Think Carefully About The Beneficiary Split
Parents usually want to divide assets equally among their children to avoid potential resentments. However, equal division before taxes doesn’t always mean equal results after taxes, especially if children are in very different tax brackets. A high-earning child who inherits the same amount as a lower-earning sibling will end up with a lower after-tax amount.
Adjusting IRA distributions to equalize after-tax amounts can address this, but it complicates the plan and often increases the family’s overall tax bill. This is because more funds will have to be directed to the beneficiary that is subject to the higher tax rate. In such cases, adjusting the division of assets of Roth IRAs or taxable brokerage accounts (which receive a step-up in basis at death) can equalize after-tax outcomes and also reduce the total tax owed across all beneficiaries, resulting in larger amounts for all.
Planning is the key
There are many ways to reduce the IRS slice of your IRA, but without planning it may be difficult to mitigate the tax implications when it becomes an inherited IRA. Such planning requires careful analysis, ongoing adjustments, open conversations between owners and beneficiaries and help from their advisors. For families seeking to transfer wealth efficiently, however, the effort is well worth it.
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