If you don’t like your children…leave them your retirement plan.

For many Americans, the majority of their wealth is found in their home, a few investments, and their retirement plan. Upon one’s demise, all of these pass to your spouse, free from tax. However, when your spouse passes, watch out! Many well-meaning retirees think they are being magnanimous leaving everything to the kids. Not so fast!

The Luxury of Step Up

Under current tax law, the home and investments receive what is known as a ‘step up in basis’. This means Suzy and Johnny inherit these assets as if they had purchased them on the date of death. The tax on capital gains is eliminated. Imagine Dad & Mom bought a stock for $25 per share twenty years ago, and now it is worth $100 per share. Had the parents sold those shares before their passing, capital gains taxes would have been paid on the $75 per share reducing the profit by 25% or more. However, when inherited, the kids obtain the stock at $100 per share, which becomes their new basis. The $75 per share capital gain is wiped out, no tax! (Note: the 2020 Democratic platform supports repeal of the ‘step up in basis at death’ rules from the tax code. Stay tuned…)

Stretching Out Withdrawals

Retirement assets such as 401K’s, IRA’s, 403B’s, and others don’t get this luxury. There is no ‘step up’ when these get passed down. In fact, when a child inherits a pre tax retirement asset from their parents they are required to begin taking distributions and paying tax on these withdrawals. For years this tax was normally not very punitive. The child was allowed to ‘stretch’ out the withdrawals over their life expectancy. This means they could take a relatively small amount out each year and pay tax on it. Since most beneficiaries are working adults paying taxes, the withdrawals would just be taxed at their normal tax bracket.

The SECURE Act Forces Action

As of December 2019, those days are gone! Congress passed, and the President signed, the SECURE Act. This Act eliminated ‘Stretch IRA’s’. Under the new law, all inherited retirement assets (including Roth IRA’s) must be paid out within 10 years following the death of the parent. This could be problematic at the least, and damaging at the most from a tax standpoint. Suppose an adult son inherits a $1M IRA from his mom. Also suppose that son is working and earning $80,000 a year. Under the SECURE Act, the son must begin taking distributions and withdraws $100,000 from the IRA in year one. This raises the son’s taxable income from $80,000 to $180,000. This raises his federal tax rate from 22% to 32%, under present tax rates. Add in your state taxes, and the son will lose from a third to over forty percent of his inherited IRA, and the taxes on his pay will go through the roof thereby reducing his take home pay! Don’t think for a minute Congress didn’t know what it was doing to raise money in this era of a huge federal deficit!

So what can you do about it?

Here are a few tactics to improve this situation: 

First, Consider taking more money out of your IRA now! Increase your withdrawals and use the extra amount to buy life insurance to replace the IRA to pass along to your kids. Life insurance death benefits are free from income, capital gains, and potentially estate taxes. The death proceeds would pass without any of the negatives, no tax, and no impact on your child’s tax bracket.

Second, if you happen to have company stock in your 401K, ESOP, or Profit Sharing Plan, FREEZE!!! There is an exciting new, patent pending, financial solution- The ROQS™ Method (Retirement Optimization of Qualified Stock) which can alleviate the tax problem for your kids, improve your retirement income substantially (often 20-25%), and benefit Charity, Win-Win-Win!!!

Third, give it all away! Even here the IRS gets their pound of flesh before the rest goes to charity. At least it won’t affect your children’s taxes. Let them fend for themselves!! (No one will do this but it’s fun to think about when the kids don’t call….)

So there you have it! It would be a shame for all your hard-earned money to go to Uncle Sam when you pass. Regardless of whether you want to benefit your kids or charity, there’s a better way than to just leave it all exposed to taxes. The choice is yours. Call your financial advisor and have a little chat. Or, give us a call and we’ll have a little chat to show you how to create better outcomes.

Or, ‘If you don’t like your children…Leave them your retirement plan…’ ????

Bill Lloyd

William R. Lloyd, CFP®, ChFC, AIF®, CPFA, M.Ed. is a thirty-year financial advisor specializing in advanced tax strategies.