Don’t leave your kids a tax bomb

Tyler Kert
Tamarack Wealth Management

Imagine you've spent 40 years diligently saving for retirement. You contributed to your 401(k), rolled old accounts into an IRA, invested consistently, and watched the balance grow. By the time you retired, you accumulated $2.2 million in pre-tax retirement accounts. That's quite an accomplishment.

But here’s a question that many individuals have not researched: What happens to that money when I die? If the majority of your retirement savings is in a traditional IRA, the answer is more complicated than simply "my kids each get a million dollars."

Based on the current rules under the SECURE Act, most adult children who inherit a traditional IRA must withdraw the entire account within 10 years. Why, you might ask? Because the IRS knows that as long as money stays inside a traditional IRA, they don’t get their share. The IRS makes the rule that beneficiaries have to drain the account in 10 years so they get paid. There are a few exceptions for disabled individuals and other unique situations but generally that is the rule.

By the time you pass, your child will probably already have a perfectly good income. Not only that, they’re probably earning more than they ever have before. The average age of inheritance is in your 50s. Statistically, your peak earning years are also in your 50s. So what does your child end up with when they inherit your 1.1M IRA at 54? A tax problem at best and a tax bomb at worst.

Suddenly, an inheritance could be adding $100,000 or $200,000 of additional taxable income on top of their salary every year. With that additional taxable income, your kids’ earned income may be subject to much higher marginal rates than you ever paid while you were accumulating the money.

What’s the solution? There is no simple fix but the first step to resolving the issue is to know that it exists in the first place. If you’re perpetually shoveling pre-tax money into an account without considering how or when you’re going to get the money back out in a tax efficient manner, well, you’re the person I’m hoping will read this article.

Depending on your individual situation, one possible solution to this problem is doing Roth conversions. As a reminder, a Roth conversion takes your pre-tax retirement savings and converts that into post-tax Roth money. The only catch – you have to pay ordinary income tax on the amount you convert in any given year. This is where planning comes in. If you’re willing to run some numbers, you can make an educated guess on the tax bracket that you will likely spend most of your time in while you’re in retirement. If your retirement tax bracket is lower than your current tax bracket, don’t do a Roth conversion. But if your income is seasonal, or you have a few years early in retirement where your tax rate is relatively low, you may uncover some opportunities.

Another solution is to change your contributions and start contributing to Roth accounts now. Retirement plans that offer the ability for employees to make Roth contributions are growing in popularity. If you already have a substantial pre-tax balance built up, maybe consider splitting your contributions 50/50 between Roth and traditional money going forward. Remember, tax brackets can and do change. I’ll let you decide where you think tax brackets are headed in the future. Ultimately, we don’t know how tax brackets will change in the next five to ten years but if you think taxes might go up, that’s another reason to contribute to your Roth.

The point is to stop thinking about inheritance planning as simply dividing up your accounts after you're gone. Think about the tax consequences of what you're leaving behind. A $1 million traditional IRA and a $1 million Roth IRA may look identical on a statement, but they are very different inheritances. And, of course, none of us knows when we're going to die. Someone who passes away unexpectedly at 55 will never have the opportunity to execute a decades-long Roth conversion strategy. That's part of life, and sometimes the tax bomb simply can't be avoided. But if you're fortunate enough to have time, you have options.

I admit, “bomb” is a strong word to use to describe an inheritance you leave behind. But I’ve seen these inheritances blow up the tax brackets of beneficiaries. Your retirement plan shouldn't end with the question, "Will I have enough to retire?" There’s another question worth asking: "How can I leave behind the most after-tax money possible?" The biggest inheritance isn't necessarily the one with the largest account balance. It's the one that leaves your family with the most money after Uncle Sam takes his share.

This material is for informational purposes only and does not constitute financial, investment, or tax advice. Please consult your tax advisor or financial planner to discuss your specific circumstances before making any decisions. Securities offered through Cetera Wealth Services LLC, Member FINRA/SIPC. Advisory services offered through Cetera Investment Advisers LLC, a registered investment adviser. Cetera is under separate ownership from any other named entity.

Tyler Kert, a financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA. 209 Woodring Street, Cashmere, WA 98815. (509) 300-1040.