Two things in life are certain: death and taxes, but have you ever considered the impact your death has on the taxability of your assets? Depending on how you are saving, you could potentially be passing a tax burden onto your heirs.
There are three different ways accounts are treated for tax purposes: 1099 now (taxable), 1099 later (tax-deferred), or 1099 never (tax-free). Most investors and advisors focus on the taxability and liquidity restrictions of assets while you are living. This is very important, but if you are a legacy-minded investor, you also need to consider how this affects your beneficiaries. Under current tax law and the Secure Act passed December 2019, understanding how these assets transfer is more important than ever.
Tax-deferred accounts are those investments that are typically geared towards your retirement. Your contributions are made on a pre-tax basis (with the exception of non-qualified annuities), and your investment grows tax-deferred meaning that you don’t pay any taxes until you take money out. This can be very valuable if you are in a higher tax bracket during your working years and expect to save on taxes in retirement. However, these accounts are NOT designed to pass onto beneficiaries very efficiently. In fact, the Secure Act makes these accounts even more restrictive for beneficiaries. Under the old tax law, when someone inherited a qualified retirement account, they were able to stretch out the tax burden over their life expectancy. Now, under the new Secure Act, those beneficiaries are required to distribute the entire account balance within 10 years. There are some exceptions to this rule for spouses or minor children, for example, but the sole purpose of this is to create taxable distributions so tax revenue can be generated at the expense of your beneficiary.
Tax-free accounts, specifically Roth IRAs, are funded with post-tax contributions. Your money then grows without generating taxes, and as long as you meet a couple of requirements set by the IRS you are able to take money out tax-free. Your beneficiaries can even take advantage of tax-free distributions. That’s great, right? Maybe. In order for Inherited Roth IRA distributions to remain tax-free, the same 10-year spend down rule from tax-deferred accounts is applied. That's not the worst thing in the world, but it can create some serious spendthrift issues. Imagine “18-year-old you” inheriting a $250,000 Roth IRA and the IRS telling you that you have to take roughly $25,000/year in extra income. Would you spend it responsibly?
Taxable accounts are those that don’t receive preferential tax treatment like the other two mentioned above. With these accounts, you are paying taxes each year on dividends and realized gains. If you hold a security for 12-months or longer, then your gains are taxed at a lower rate, and if you are working with an advisor who does tax-loss harvesting, these accounts can be used to mitigate taxable gains. So, there is some tax benefit related to these investments while you’re living. Taxable accounts are the most efficient for transferring wealth to a beneficiary. When an account owner passes away, the cost basis is reset to whatever the value of the account was the day that individual passed away. So your beneficiaries get a “reset” button on taxable gains and essentially receive the account tax-free with no input from the IRS how this money then gets distributed.
Understanding your goals pre and post death are incredibly important when developing a financial plan. Legacy-minded investors need to not only think about being tax-efficient during their lifetime, but how to avoid passing a massive tax-burden to their beneficiaries. For more information on how to properly structure your savings, please contact the office at 800-804-0420 or online at www.fsgmichigan.com
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Written by Justin Meyer