Think Twice When Leaving an IRA to the Next Generation

With the passing of the Secure Act 2.0 of 2022 (Secure 2.0), new laws have been put into place that make the decision to leave pretax retirement assets to the next generation less desirable.   

When you transfer assets upon your death, you need to take into consideration the tax treatment of those assets.  While assets can be transferred between spouses generally tax free, other beneficiary options have some pretty serious tax events.  When a non-spousal heir receives assets like real estate, stocks, bonds, mutual funds or ETFs, they will receive those assets with a step up in basis.  A step up in basis allows them to create a new basis amount equal to the asset’s value on the date of death and no tax would be due on that transfer.  If you were to sell that asset before you die, then capital gains taxes would be owed on that sale. The step up in basis rule is a very valuable tool in estate planning as it allows the next generation to mitigate the gain of an asset that you may have held for many years.   

Any pretax accounts that you may have established for retirement planning purposes, even though you funded them with stocks, bonds or mutual funds, would not receive that step up in basis.  The beneficiary would be required to pay income tax at their marginal tax bracket on those assets when they make withdrawals.  In the past, the IRS allowed the beneficiary to make withdrawals based on their life expectancy.  This allowed them to “stretch” the tax liability out over many years.  This has changed with the passage of Secure 2.0.  Some beneficiaries are still allowed to make withdrawals over their lifetimes.  They are referred to as “Eligible Designated Beneficiaries” (EDBs). EDBs are surviving spouses, minor children (only until the age of 21), disabled or chronically ill individuals or individuals who are less than 10 years younger than the deceased.  All others must make those withdraws within 10 years of death.   

This can have a major effect on the tax liability of those assets.  If you were to leave your $1,000,000 IRA to your son or daughter, chances are that you will be adding to their tax liability substantially over the next 10 years.  Even if they took $100,000 out a year for 10 years, they would still have almost $400,000 remaining in year 10 that they would have to take as ordinary income (assuming the remaining balance was invested earning 5%).  This is income that will be in addition to their normal income, possibly pushing them into the highest marginal income tax bracket.  If your non EDB beneficiaries live in a state with state income tax, there is a chance that they will lose much of their inheritance to taxes.   

There are a few planning options to avoid this tax liability for your beneficiaries.  One would be to start paying premiums on a life insurance policy with those IRA dollars while you are alive and leave a tax-free death benefit to your beneficiaries.  This allows you to pay the tax on the withdrawal while you are alive, theoretically at a lower tax bracket in retirement than your grown children.  Additionally, if you have assets that are transferred with a step up in basis, as discussed earlier, leave those to your beneficiaries and spend the IRA for income while you are alive.   

No planning is cookie cutter, and you should make decisions based on your unique situation, but I hope that you have gathered enough information in this article to start that planning process.   Feel free to give me a call if you have further questions. 

I do not offer tax or legal advice.  Please seek tax or legal advice from your own advisor.  Taxes are one of many items to consider as you evaluate financial strategies and products. Other items to consider include your specific risk tolerance, financial goals, time frame for your financial goals, and the need for liquidity.