The following is excerpted from Chapter 11 in Wade Pfau’s new book, Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success. It is available at Amazon, Barnes & Noble, Target, and other leading retailers.
[Author’s note: William Reichenstein recently wrote a piece for Advisor Perspectives that objects to my use of the term “tax-bracket management” when I am including non-linearities in the tax code that cause marginal tax rates to different from the federal tax brackets for ordinary income. If this is confusing, replace “adjusted gross income management” with “tax-bracket management” in your mind as you read the following. The ideas that Reichenstein described in his column are already fully embedded into this analysis.]
We now shift to a discussion of taxes and legacy when estate tax is not a concern because asset levels are below the estate tax exemptions. We described tax-efficient retirement distributions in Chapter 10 as the process of using tax-bracket management and strategic Roth conversions. Tax-efficient distributions generally involve spending from a blend of taxable and tax-deferred assets first, and then from a blend of tax-deferred and tax-free assets once the taxable accounts have been depleted. When considering how to position financial assets also for inheritance, we include:
- The step-up in basis available for taxable assets at death means that bequeathing appreciated securities can avoid capital gains taxes compared to if those assets are sold during one’s lifetime.
- Tax-bracket management should also incorporate the marginal tax rates that heirs will pay on any inherited assets.
- When multiple heirs face different tax rates, the inheritance can be designed to improve efficiency by having unequal pre-tax inheritance amounts that are equalized after tax payments to provide more after-tax value for all recipients.
Addressing these matters in order, an important aspect of the tax code is that capital assets receive a step-up in basis at death. This means that the cost-basis for determining taxes is reset to the fair market value of the asset at the time the owner dies. This is relevant both for taxable assets held in brokerage accounts as well as for real estate and other related assets that track a cost basis for tax purposes. As for exceptions, annuities and retirement plan assets do not receive a step-up in basis. For assets experiencing large appreciations, the step-up in basis can imply a huge reduction in potential capital gains taxes. Sell the asset while alive and capital gains taxes are due; leave it for an inheritance and those capital gains taxes disappear. Joint ownership of assets such as real estate can eliminate the possibility of receiving a step-up in basis at death, though for community property a complete step-up may be possible at the death of either owner. Losing the potential for a step-up in basis can create a costly tax mistake for appreciated assets.
To consider a simple example, suppose you have a long-held mutual fund in a taxable brokerage account worth $100,000 with a cost-basis of $40,000. You could sell it to cover retirement spending and then pay long-term capital gains rates on the $60,000 of gains. However, if you instead leave this asset for heirs, its cost basis resets to the $100,000 fair market value at the time of death. If then sold at this price, there will be no capital gains taxes to be paid by the heirs.
This possibility speaks to the idea that it may not always be wise to fully spend down taxable assets first. In some cases, as legacy planning becomes realistic, it may prove wise to hold on to some highly appreciated taxable assets so that their embedded capital gains can avoid taxation when inherited. As for a related point, some assets may experience losses and be worth less than their cost basis. It might be wise to sell those assets while alive to receive a tax deduction on the losses that would be lost at death when there is a step-down in basis.
The next point relates to the marginal tax rates paid on distributions from IRAs and other tax-deferred retirement plans. We spoke in Chapter 10 of reducing the marginal tax rates paid through tax-bracket management and strategic Roth conversions. Taxes must be paid at some point, and the strategy is to trigger taxable income when the tax rates applied to that income are relatively low. The extension to consider here is that when these IRA assets are inherited, tax-bracket management also extends to include the marginal tax rates paid by the account beneficiaries.
Peak earnings years often happen at around age 50, and this age may also coincide with when beneficiaries are inheriting IRAs from their parents. The SECURE Act speeds up the process for many beneficiaries to take required distributions, allowing for ten years to fully distribute an inherited tax-deferred account and pay taxes on the proceeds. This eliminates the previous ability to stretch distributions from inherited accounts over one’s lifetime (we discuss this further later in the chapter). With the SECURE Act’s ten-year window on distributions, beneficiaries may increasingly be forced to take distributions during peak earnings years and, therefore, at higher marginal tax rates. The implication is that the advice to pay taxes when the tax rates are lowest might increasingly suggest Roth conversions to retirees who may be in lower tax brackets than their beneficiaries.
It is also quite possible that multiple beneficiaries may be in different tax brackets. Perhaps one adult child is a high earner facing high marginal tax rates while another adult child has a more modest income and faces lower tax rates. A desire to be fair might suggest dividing all accounts equally between the two children. But a more tax-efficient approach would be to lean toward leaving taxable accounts and Roth accounts to the high earning child and leaving IRAs to the low earning child. This way, lower tax rates can be applied to the IRA distributions.
One can also consider what is meant by “equal” inheritances. Should the amounts be equal before tax or after tax? In this scenario, the low earner will be stuck paying taxes on IRA distributions while the tax bills will be less for the high earner receiving assets that are not taxed. This speaks to providing a larger monetary amount to the low-earning child such that after taxes are paid, the inheritance values will be more equalized. When strategizing in this way, it is worthwhile to explain to your heirs what you are doing so that they do not view it as unfair and understand that this can lead to a larger after-tax inheritance value for each of them than a simple equal splitting of each account value. We generally view monetary amounts in gross terms rather than in the more relevant after-tax terms, and that thinking can lead to less after-tax value for beneficiaries.
This concept is complex and is worth providing a simple illustration. An estate consists of $100,000 in an IRA and $100,000 in a Roth IRA. Two adult children will be the beneficiaries of these accounts. One child will be in the 37 percent marginal tax bracket while the other child will be in the 12 percent marginal tax bracket. First consider if these accounts are split evenly between the children, with each receiving $50,000 from the IRA and $50,000 from the Roth IRA. The $100,000 pre-tax values will not be the same after taxes. For the high tax child, the after-tax value of the inheritance is $81,500. This consists of $50,000 from the Roth IRA and $31,500 net-of-taxes from the IRA. For the low-tax child, the after-tax inheritance is $94,000 after paying 12 percent taxes on the IRA component. The combined after-tax inheritance value is $175,500.
But consider a different distribution. The high-tax child receives an inheritance of $94,000 from the Roth IRA, while the low-tax child receives the $100,000 from the IRA and $6,000 from the Roth IRA. As the low-tax child received $12,000 more than the high-tax child, this may not seem fair. But consider the after-tax impact. The high tax child still has $94,000 after taxes. The low-tax child has $88,000 from the IRA after paying 12 percent taxes and $6,000 from the Roth IRA, for a total of $94,000. They both received $94,000 after paying taxes, for a combined after-tax value of $188,000. This is $12,500 more combined after-tax inheritance than in the case where accounts were split equally. Even though the pre-tax inheritance values were not equal, both children should be understanding of the situation once the after-tax implications are made clear.
A final variation on this applies to those with charitable intentions as part of their legacy and who own a variety of account types. IRAs and other tax-deferred accounts may be the best suited for charitable donations. IRAs carry embedded income tax requirements for their distributions that qualified charities do not have to pay. Roth IRAs and taxable assets with a step-up in basis will then be better suited for receipt by individuals. As a related point, it would not make sense to engage in Roth conversions for assets that you intend to donate to a tax-exempt charity.
The Retirement Planning Guidebook is designed to help readers navigate the key financial and non-financial decisions for a successful retirement. The book includes detailed action plans for decision making that can assist advisors and their clients. It is available at Amazon, Barnes & Noble, Target, and other leading retailers.
Wade D. Pfau, Ph.D., CFA, is the curriculum director of the Retirement Income Certified Professional program at The American College in King of Prussia, PA. He is also a principal and director at McLean Asset Management and RetirementResearcher.com.
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The following is excerpted from Chapter 11 in Wade Pfau’s new book, Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success. It is available at Amazon, Barnes & Noble, Target, and other leading retailers. 