Estate Planning for a Taxing Inheritance

Estate planning should address tax planning to accomplish several goals. In addition to minimizing tax liability, tax-sensitive estate planning can ensure family members inheriting wealth are given a helpful asset, not a costly one. A recent article, “Inheriting Tax Liabilities” from Financial Advisor, explains how this can be done.

A beneficiary inheriting a pre-tax traditional IRA has to pay full state and federal income tax on any withdrawals, which must occur within ten years. Demographics show this inheritance most often occurs when the heirs are in their careers' highest tax income bracket, making it a double tax whammy.

There’s no step-up in basis for a traditional IRA. A $3 million IRA isn’t a $3 million IRA when it’s inherited. If the person inheriting the IRA is in a high-tax state and is also a high-income earner, they could lose nearly 45% every year when taking their required distributions.

The timeframe for IRA inheritances is tricky. Let’s say a couple works hard and saves in their tax-deferred 401(k) for three decades. When they retire, they roll those savings into traditional IRAs. When the second spouse dies, her children will probably be 55 to 60 years old, when people are usually in their highest earning and taxable years.

Another hitch: inherited IRA distributions can’t be donated to charity or kept in the IRA to be passed along to the heir’s children.

How to address this? It depends.

If there are two adult children and one has more modest wages and resides in a low-tax state, giving the lower-income heir a larger percentage of the IRA will result in a larger after-tax amount. If the other child is a high-income earner, bequeathing after-tax assets may make more sense. The two heirs may end up with the same amount when adjustments are made to their circumstances.

In some instances, it makes sense for the parents to convert traditional IRAs to Roth IRAs and pay the taxes to give heirs the advantages of the Roth IRA. Another strategy is to bequest pre-tax IRA assets to a charity and give heirs tax-free assets.

Think less about equal inheritances and more about adjusting assets to end up with the same spendable savings.

The same adjustments will be helpful when planning for illiquid assets like the family home. Preparing assets like real estate or art collections requires time, and the cost of commissions and marketing can reduce the inheritable value of the assets.

An inheritance is a gift to loved ones, improved by clear-sighted estate planning that considers the individual family’s circumstances in more depth. Review your family’s entire picture with your estate planning attorney so the results will truly be what you wish.

If you need help understanding taxing inheritance, or if you are going through a probate case, we are always happy to help. Our Los Angeles probate attorneys can guide you through it.

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Reference: Financial Advisor (March 15, 2024) “Inheriting Tax Liabilities”