Changes in tax laws have made estate planning a top priority when it comes to leaving retirement savings accounts to heirs, says a recent article from The Wall Street Journal, “How to Leave Grandkids Your Retirement Savings—and Not a Huge Tax Bill.”
Heirs who are not spouses have to empty inherited retirement accounts within 10 years of the death of the original owners, with few exceptions. Before the law changed in 2020, heirs had decades to do this, enjoying tax-free growth.
For many families, these changes require drawing up new trusts and changing estate plans to maximize the family’s after-tax wealth. Some also make a series of Roth conversions or significant generation-skipping lifetime gifts.
How much is at stake? Americans held $12.5 trillion in IRAs as of March 31, and about half of households headed by someone 65 and older have an IRA.
A gradual conversion from traditional IRAs to Roth IRAs makes sense for many, so children and grandchildren can inherit the money tax-free. The taxes are being paid upfront. Once the money is in the Roth, it grows tax-free, and heirs can take it out tax-free when they inherit.
If the inheritance occurs during the grandchildren’s or parents’ highest earning years, they can cause a massive tax bill. Minor grandchildren might need to file a tax return to report the IRA payout, and the income could be taxed at the parent’s rate.
For many grandparents, the solution is to make lifetime gifts to grandchildren as soon as they are born, from paying for diapers and preschool to setting up 529 college savings plans and having trusts created and funded to save estate and generation-skipping transfer taxes.
Leaving an IRA outright to grandchildren, even with the ten-year payout period, is usually not a good idea. They may see the inheritance as a windfall and go through it quickly. Having conversations about your intention for their use of the money is a good idea. However, it’s not legally binding.
Inherited IRAs also come with administrative headaches. You can’t convert an inherited traditional IRA to a Roth IRA, add money to an inherited IRA, or combine an inherited IRA with your own IRA.
Leaving an IRA in a trust may seem complicated. However, it's a worthwhile move if there are concerns about how parents or grandchildren might handle an inheritance. A trustee would distribute the money based on the terms set in the trust. This prevents the scenario of a young adult inheriting more money than they’ll know what to do with.
Your estate planning attorney will be able to help your family minimize the tax impact of inheritance with a comprehensive plan.
Reference: The Wall Street Journal (July 9, 2023) “How to Leave Grandkids Your Retirement Savings—and Not a Huge Tax Bill”