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How to Minimize Your Heirs’ Tax Burden on Inherited IRAs and 401(k)s

The stretch-IRA strategy largely went away after the Secure Act of 2019, leaving heirs less maneuverability on taxes. Financial pros have some solutions.

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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 such as Timothy Steffen are suggesting parents consider treating high-income children different from their lower-income siblings to provide more equal inheritances on an after-tax basis.

Steffen, director of tax planning for Baird Private Wealth Management, provides this 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, Steffen said. 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.

To be sure, Steffen notes that 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 reason: “It’s the kids’ problem,” said Steffen. Others say: “I don’t want my child to miss out on $1 million. I’ll fix it.”

When parents do want to adjust beneficiary allotments based on children’s incomes and taxes, Steffen notes it isn’t a “set it and forget it” strategy. Beneficiary designations should be revisited annually so they can be redone if there has been a significant change. For example, over time, an affluent child could lose a job or a lower-income child could move into a high-income career.

Even if parents simply want to divide all their accounts equally between their children, parents have options that can lower the taxable hit to their heirs.

One option: Parents could convert some IRA money to Roth IRAs, said Steffen. But parents must realize before doing any conversion that they will pay income tax on anything they move from an IRA to a Roth in a single year, so it’s best to make this move before or during retirement when in relatively low tax years. What’s more, it might not be sensible if parents have been in high tax brackets and children are likely to be in low tax brackets when they eventually receive an inheritance.

Another option for parents who have both traditional IRAs and Roth IRAs is to tap the two types of retirement accounts differently so heirs end up with more in a tax-friendly Roth inheritance. The idea is for parents to take their own retirement spending money each year from their IRA, and preserve the Roth so it can be passed to children free of taxes.

For some parents with limited resources or the need to reduce their annual taxes by taking some money annually from a Roth and an IRA, preserving the Roth may not work. But parents with plenty of money in traditional IRAs, could use them exclusively for living expenses and charitable contributions while reserving the Roth for a possible inheritance for their children.

Write to retirement@barrons.com

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