When parents leave their children an inheritance, assets are most often split equally among siblings. But equal isn’t always equal when they leave individual retirement accounts or 401(k)s to adult children with big differences in income—at least not anymore.
Before the Secure Act of 2019, adult children who inherited retirement accounts had significant leeway to control what they withdrew annually and the resulting taxes. While they had to take some money out every year and pay taxes, they could limit those taxes by spreading those withdrawals over a lifetime.
Now, for most adult children, IRAs and 401(k)s must be drawn down within a 10-year period after a parent dies, meaning withdrawals—and taxes—could be sizable whether the disbursements are taken in intervals or in a lump sum by year 11.
Since the new rules can inflict high taxes on adult children, particularly high earners, some financial planners are advising parents to keep their children’s income and typical tax status in mind when naming beneficiaries on IRA or 401(k) forms.
Rather than chopping an IRA or 401(k) into equal parts, financial planners are suggesting parents consider treating high-income children different from their lower-income siblings to provide more equal inheritances on an after-tax basis.
Here is a simplified example about the consequences of not keeping taxes in mind. Consider two adult brothers—one in the 35% tax bracket, and the other in the 22% bracket. Their mother has $2 million in a traditional IRA, $1.25 million in a Roth IRA, and $1 million in nonretirement accounts such as savings and brokerage accounts. She wants to be fair, so she fills out beneficiary forms so each account is divided 50/50—leaving $2.125 million for each child.
When the children get the inheritance, the son in the 35% bracket ends up with just $1.775 million in value from the original $2.125 million inheritance. But the son in the lower tax bracket ends up with $1.905 million in value. In other words, the mother has left one son with $130,000 less than the other son after figuring in the impact of taxes.
If the mother wants to avoid this hit to the inheritance, there is a possible solution. The mother could leave the entire traditional IRA to her lower-income child, the entire Roth IRA to the higher-income child, and also leave a greater portion of her savings and brokerage account to the higher-income child.
The reason: Roth IRA withdrawals are never taxed. So although the affluent son will have to empty the Roth within 10 years of his mother’s death, he won’t need to pay any taxes on it.
As a result, in this simple example based on the sons’ initial tax brackets and income, both siblings will receive inheritances that are close to the same on an after-tax basis.
This approach can require more attention than some parents want to devote. If there’s money left in an IRA when they die, some parents feel “It’s the kids’ problem,” others say “I don’t want my child to miss out on $1 million. I’ll fix it.”
Read the full article here.
By Gail MarksJarvis contributor at Barron’s
Published July 2, 2022