For many workers and retirees, it’s a delicate balance between wanting to live comfortably and wanting to leave something behind for loved ones. Which assets do you use to live in retirement? Which do you save to pass down? Considering the tax implications, this is a very important question to consider.
Retirees are often told to plan their spending, but this doesn’t normally include the sources of spending. With this in mind, we have some advice today!
Estate Planning
Although you might be tired of hearing it at this point, the first step for estate planning is always to think about goals. When making changes to your plan, the same is true. How much do you plan to leave behind for children and grandchildren? Did you want to leave a chunk of your money to charity?
The best way to use your assets wisely in retirement is to learn all about your accounts and how they work. Learn how each passes down to children, how you’re taxed on withdrawals, etc. Wherever possible, title your accounts and ensure that the beneficiaries are listed correctly.
Of course, it’s not good enough to just do this once. Instead, you should update your estate planning every time a major life event occurs. Also, you should adjust your plan when your goals change, or the tax rules change.
Planning Finances in Retirement
For those getting close to retirement, you will have heard about the importance of reviewing income and investments. As well as annuities, Social Security, and pensions, you’re likely to have taxable investments. At this stage, you’ll need to consider potential RMDs (required minimum distributions) with qualified plans such as IRAs. While this previously started at 72, the rule has now changed to 70 and ½.
When planning finances in retirement, it’s important to differentiate between core capital and excess capital. In the former, this should contain enough to cover annual expenses. Meanwhile, excess capital is free for unexpected long-term care requirements or medical bills. If you still have excess retirement funds after this, plan for them to pass down to heirs (without these heirs having to pay heavy tax and other fees!).
Managing Wealth Transfer
Too often, we see retirees only taking the first step of arranging funds for day-to-day expenses. They forget the wealth-management aspect, and this means that you aren’t getting the most from the excess capital, both in terms of investments and tax.
Sadly, passing assets down to children is a tricky subject and one that causes problems for thousands around the United States each year. In many cases, a traditional IRA is actually worse than highly appreciated taxable investment accounts. Why? Because the latter allows your beneficiary to avoid capital gains tax on appreciation by selling appreciated assets – this is thanks to a step-up in cost basis.
As an example, let’s say that your child will receive 2,000 shares in stock. We’re using a child in this example, but it could be any heir after the passing of a loved one. Each share has a cost basis of $15 but they’re now valued at $100 per share. Here, the heir wouldn’t have to pay capital gains tax on the additional $85. However, if you were to sell these shares before dying, the amount would have been taxed fully.
Naturally, any appreciation that occurs after the death of the owner is taxable. Despite this, the vast majority isn’t, and this makes it a brilliant asset to pass down to heirs. If you’re to choose this route, bear in mind that lawmakers may change the way that this niche works in the future. We’ve already seen a proposed STEP Act that would remove the tax break for gains of over $2 million for married couples and $1 million for individuals.
Tax-Deferred Assets and IRAs
One of the most important details with qualified assets such as traditional IRAs is that they don’t have a step-up basis. If you pass down $150,000 in an IRA, for example, your heir will pay their income tax rate when withdrawing. In other words, an heir in the 37% marginal income tax bracket could lose a significant chunk when withdrawing everything in one lump sum.
Unfortunately, there’s a balance between doing what’s right for yourself and taking positive steps for your heirs. Although deferring taxes helps you in life, it causes problems for your heirs. If you find that your qualified plan, such as a traditional IRA, isn’t critical to your retirement goals, you then need to decide what happens to the account. If you want an heir to inherit the account, consider converting as much as possible to a Roth IRA. By paying some taxes now, the new amount grows free from tax, and you help your heirs in the long term.
After the conversion, you don’t need to make taxable distributions, and the same requirement is also avoided for spouses and beneficiaries. As well as growing tax-free, it’s also distributed tax-free over a period of time, which is ten years for those the SECURE Act lists as eligible designated beneficiaries.
In short, inheriting a large account from loved ones is a nice sentiment, but often a hefty tax burden. If you have excess capital in an account like this, consider converting to a Roth IRA to pay some of this tax while you are still alive. You’ll pay the tax early while the account still has plenty of time to grow. If you’re to make this move, make sure you have enough money elsewhere to not only live off of but also to be able to pay the income tax on the conversion.
Charitable Donations
You want to pass money to a charity, and you want them to receive as much money as possible. If this is the case, one option is to name the charity as a beneficiary on your retirement plan. Even with a traditional IRA, charities receive this money without having to worry about tax. Additionally, this could lead to an estate deduction on state and federal estate taxes.
Ultimately, planning is key in retirement. You need to cover day-to-day expenses while estate planning to prevent your heirs from getting taxed heavily and losing access to large chunks of your savings. If your savings exceed spending goals, think about the tax consequences for heirs and alleviate some of the burdens while you’re still alive.
If you need help managing assets for spending and passing funds down to family, speak with a financial advisor for tailored advice!
