The financial goal of many retirees is the straightforward need to have enough money until they die. Leaving a legacy to their children often comes second, provided that a long lifetime, medical expenses or poor market performance leave something extra at the end. Despite this uncertainty, it is possible to optimize any potential gift to one's heirs by making sure you're spending down the right assets first and keeping an eye on your tax situation.
Taxes really are the issue to consider, and here, not all assets are created equal. In particular, consider how to handle these three types: taxable assets, tax-deferred assets and tax-free assets. (These are separate from more well-known rules on estate taxes, which won't be considered here.)
Start with taxable assets. These consist of non-retirement holdings, and can receive a step up in basis treatment at death. They're taxed at their value at inheritance rather than their lower purchase value, and that can mean a lower tax bill. Here's how: The heir receives the security with a basis equal to fair market value as of the date of death. What this means is that the capital gains tax is avoided on any unrealized gains. For example, consider an individual who owns $100,000 in stock that was bought for $10,000. If he sells the stock, he will have to pay tax on the $90,000 gain, or $13,500 for an individual in the 25 percent income tax bracket (where he pays a 15 percent capital gains rate), leaving $86,500 from the sale. If the stock is left to one's heirs, their basis would step up to $100,000; if they decide to sell, they get the full amount. That's why it might be best, if possible, to tap market-value assets first, like money in checking accounts or money market funds where there's no tax benefit. Spend these first.
Next, look at your tax-deferred assets. These are generally worth holding onto as long as possible due to their greater growth rate resulting from tax-deferral. However, there are some qualifications to this rule of thumb. First, there are minimum distributions that have to be taken from retirement accounts once the owner reaches age 70½. Usually, it is a good idea to limit withdrawals to the minimum, provided other income sources are available. However, given the new, Net Investment Income Tax (commonly known as the Medicare surcharge), it is important to monitor annual distributions in order to keep from moving to a higher tax bracket. Since withdrawals from qualified accounts like 401(k)s and IRAs may push modified adjusted gross income above the threshold that triggers NIIT, it may actually make sense to begin larger withdrawals early if you're already in a higher bracket in order to make sure withdrawals down the road don't keep you in that bracket longer than needed as your annual income decreases. A second reason for withdrawing money from a tax-deferred account occurs when the owner's tax bracket is lower than their heir's. Anyone withdrawing money from a retirement account must pay ordinary income tax on all funds withdrawn, including a beneficiary who receives a retirement account upon the owner's death. It might be better for a retiree in a low tax bracket to remove money from a retirement account rather than leave it to a working child who is in a higher tax bracket.
Finally, there are tax-free assets to be considered. These are Roth IRAs and Roth 401(k)s, where taxes were paid at the time funds were placed in the account so all withdrawals are taken out tax-free. Ideally, these funds are the last to be used because neither the owner nor the beneficiary pays tax on the account. Nonetheless, there are a few situations in which funds should be withdrawn from these accounts. Again, there are required minimum distributions for owners of Roth 401(k)s as well as for beneficiaries of any Roth account. Also, there are situations when pulling money from a Roth account can be used to keep a taxpayer from crossing a threshold into a higher tax bracket and crossing the NIIT threshold mentioned earlier by reducing the amount withdrawn from tax-deferred accounts.
It may be complicated, but the tax treatment of assets can have a big impact on the size of any inheritance passed to heirs. However, each person's situation is unique and may require a different approach, using the above techniques. Consult with your financial planner and accountant to determine the best strategy for your estate.
Ann G. Schnorrenberg, Ph.D., is a Financial Planning Associate at Monument Wealth Management, a Registered Investment Advisory firm located just outside Washington, D.C. in Alexandria, VA. Follow Ann and the rest of Monument Wealth Management on Twitter, LinkedIn, YouTube, Facebook, and their "Off the Wall" blog which can be found on their website.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.