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Should Your Kids Inherit Your IRA?

Updated: Mar 22

It is often reported in the financial media that Boomers are under-saving for their retirement years, and a significant portion of retirees list running out of money and healthcare costs as their top concerns in retirement. Due to this financial uncertainty, passing on any type of inheritance to one’s heirs often becomes an afterthought. However, in my experience with clients, almost everyone wants to make sure that their beneficiaries will inherit their unused assets if something were to happen to them.

Here’s what this tells me as a financial planner: people will choose a plan to maximize their lifestyle and income in retirement, but in the back of their minds, they’re also thinking about their kids. In some specific cases, people can be really concerned about their kids because they have a child who needs help or a grandchild that has special needs, and they want to be able to participate in providing for them financially. As a parent myself, I absolutely understand this mindset, and I enjoy helping parents discover ways to help their children in the context of a financial plan.

So, how do some (read: most) people try to transfer their retirement assets?

The plan, or lack thereof, is pretty straightforward: Parents will spend their assets as they need and desire during their retirement years, and IF any assets are leftover when the second spouse dies, any unused funds will go to their beneficiaries. Often times, the paper assets that kids inherit are retirement accounts like IRAs. For the sake of this post, we aren’t going to address real property (like a home) that would pass through a will or trust.

Newsflash: your kids don’t want your IRA money…not really.

I know that statement sounds crazy because you’re probably thinking that anyone would like to have any type of inheritance, even if it’s a small one. One client once said jokingly, “Even if they get a dollar, that’s one dollar more than zero.” On the other hand, from a planning perspective, we must consider the changing landscape in our nation and how wealth transfer is likely to be impacted in years ahead.

It’s not much of a secret that our government has a serious spending problem. That same government is also responsible for creating laws that govern our tax system and wealth transfer between generations. Instead of finding innovative ways to cut spending, the prevailing philosophy of the moment seems to focus on innovative ways to create more revenue; and there doesn’t appear to be any reversal to this trend coming soon. Recently, our Congress passed the Bipartisan Budget Act of 2015, which eliminated some very beneficial social security claiming strategies for the Baby Boomer generation. The idea was that these strategies were loopholes in the system, and they needed to be closed. At one point, they were even referred to as “aggressive filing strategies” by the current administration. I won’t debate the good, bad, or ugliness of that argument except to say this— they changed a massive government program without any advance warning.

If passing massive bills at midnight while we sleep is going to be the new modus operandi of Uncle Sam, we can only begin to count the days until some of the other financial planning techniques that we enjoy will become extinct, victims of a government that’s starved for more money to spend. (It should be noted that the changes to Social Security were highlighted in Section 831 of the bill, so they were buried deep into that legislation.)

One item that has been mentioned in the past is the elimination of a stretch IRA strategy. For those who may not know, this strategy allows a designated, non-spouse beneficiary of an inherited IRA to stretch the required distributions over their life expectancy instead of the original owner’s life expectancy. For instance, if you have a young adult that inherits an IRA as a designated beneficiary, they currently have the option to keep the funds invested in a beneficiary IRA and only withdraw the required minimum amount—which should be relatively small because it’s determined by their life expectancy, not the life expectancy of the decedent. This strategy can allow for a much longer time period of tax-deferred growth, which could result in a powerful wealth building strategy for a younger person.

If Congress eliminates the stretch IRA, what will likely happen is anyone other than a spouse who inherits an IRA is going to have to pick between two options: take the required distributions over a five year period, with the account balance going to zero at the end of five years, or, take a lump sum payout. Neither of these outcomes are ideal when it comes to taxes. If you have a child who’s working and making a good income that suddenly inherits a large IRA, they will have to choose between taking a tax hit all at once or a not-so-great tax hit over a five year period.

While we tend to think about inheritances as a financial windfall, we sometimes forget to think about the unintended consequences. Aside from the emotional considerations of losing a loved one, inheriting tax-deferred retirement accounts could come at a time when the beneficiary is trying to reposition assets for college planning, and the new required distributions will drive up their income they must count on FAFSA forms. Retirement assets generally are not counted when applying for aid; however, income levels are counted. Adding more income at the wrong time could impact financial aid opportunities for families trying to plan for college.

Another scenario might be that your kids already earn a high income, and they’re going to face an increase in their tax brackets, see new taxes imposed, and / or potentially lose some tax deductions because of the new inheritance. With our new health insurance laws, the increased income from an inheritance may even impact their health insurance premiums! Believe it or not, the difference in cost of subsidized health insurance and paying the full amount can be thousands of dollars per year. This is no small impact.

In short, the impact of inheriting IRA funds is not always as wonderful as you might think. There are other ways to transfer wealth to the next generation, and one of the things that needs to be considered is how can we plan for a wealth transfer where both parties benefit? There is an entire niche in our industry that focuses on wealth transfer, and for the sake of this article, I’m going to focus on one simple, powerful strategy. This strategy creates certainty, establishes a guaranteed inheritance, and allows parents to completely spend their assets without worrying about leaving behind any money.

And guess what? It can be tax-efficient, which is awesome.

Let’s say that we have a couple who has done well with saving for retirement. Over the years, they’ve worked and saved, and they now have over 1 million in their retirement accounts. Notice that we’re not talking about Bill Gates here—more the millionaire next door type of folks. They own their home, have no outside debts, and the large majority of their funds are held in IRA accounts, 401(k) accounts, or some other type of qualified retirement program. This couple decides to begin working with a financial planner to develop a comprehensive retirement income strategy—one that addresses everything from claiming social security to healthcare costs to final estate planning wishes.

Our couple is like many other couples in that they want to leave money to their 2 kids, but they aren’t really sure how to do it. Moreover, they aren’t interested in hoarding their retirement money to make absolutely sure that their kids get an inheritance. As we continue the planning conversation, we discover that they also have some grandchildren that they love to spoil; and in a perfect scenario, they’d want to help pay for college so that their grandkids wouldn’t be burdened by student loan debt.

Since both of our Boomers are healthy, we discuss the idea of buying something called a joint and survivor — or a second-to-die — life insurance policy. This policy is one that insures both the husband and the wife, and it will not pay out proceeds until the last spouse dies. They can pay the premiums monthly, quarterly, annually, or they can potentially do a one time, lump sum purchase, if a large lump sum is available. In this scenario, we will avoid using a policy that is designed to build cash value and use one that gives a permanent, guaranteed benefit for a level payment. What this type of plan design does is create certainty. Our couple can design a policy with a stated death benefit, design the premiums to fit with their retirement plan, and control who ultimately inherits the proceeds. The best part is that the life insurance proceeds should be inherited income tax free, as opposed to IRA assets.

Considering the fact that we’ve just talked about purchasing a second-to-die life insurance policy, you might be asking— how did that benefit the parents, the people who are trying to retire? Some will think that we just created an additional expense, and on surface level that is true, we did create an expense. However, we also did several other things:

First, they were actually able to put a numeric value on the assets that would go to their kids no matter what. By doing this, we’ve eliminated the uncertainty of whether or not there will actually be any funds to gift their kids when they die. A lot of people won’t openly admit this, but leaving a financial legacy is something that’s important to them. It’s one last way to say, “I love you” and provide for your child one more time.

The second thing we accomplish is making sure that new premium expense is going to be predictable, budget friendly, and remain level. It’s something that can be planned for throughout the entire life cycle of someone’s retirement years, and believe it or not, there are multiple planning techniques for creating the cash flow needed. I could go down on another tangent about specific strategies that address how to make the payments; however, let’s stay focused on the policy design instead. One of the advantages of using this type of policy is that we tend to get a lower premium rating because we’re insuring two lives with one policy. Life insurance companies can stretch their exposure for paying the benefits over 2 life expectancies instead of just one, which tends to give us a price break on the cost. If we opt to pay for it annually, instead of monthly, there could be additional savings there also. Both of these features come into play before we even consider that our couple is healthy—which again, is favorable for determining the final cost of a policy like this.

Finally, and most importantly, it frees up all of the other assets that someone has saved for retirement to be spent. Our couple can now take their retirement dollars and optimize their income strategies to provide for the maximum use of their funds. Leaving money to a beneficiary truly becomes secondary now that they own a life insurance policy that’s designed to do that. Our couple is free to spend every last dime without reservation about preserving their assets for their heirs. The funds can be used solely for their enjoyment and benefit, and if our couple still manages to have retirement assets to pass on to their beneficiaries, the added life insurance can help cover the taxes for a lump sum distribution.

One more thing—let’s talk about the taxes. The initial idea of this article was to address the tax bite of inheriting qualified retirement dollars should Congress change the tax code. Naturally, no one can predict with certainty what our tax code will look like in the years ahead. However, with Social Security, Medicare, and Medicaid growing as budget items, I believe it is fair to say that without significant reforms, tax rates are going to face upward pressure in the future. By having a tax-free asset to pass on to your beneficiaries, such as life insurance, you can circumvent that issue in a number of ways. As I mentioned above, if your kids do inherit retirement funds, they can take the lump sum distribution and use the life insurance dollars to cover the tax bill. Or, if you’re charitably inclined, you can go out with a bang by leaving your retirement dollars to a qualified charity and allowing your kids to have the life insurance. The charity wins. Your kids win. You go out with bang.

Obviously, this type of planning should be done in the context of an overall financial plan, as there may be several moving parts to making this work. There are multiple items to consider, and the goal of this post was to simply illustrate an alternative planning concept to the status quo. This type of program is definitely not a one-size-fits-all approach, but for the right circumstances, it can be a great strategy. If you’re interested in learning more, click here.

Investment Advisory Services offered through AlphaStar Capital Management, LLC., a SEC Registered Investment Advisor. AlphaStar Capital Management, LLC and Vertex Capital Advisors, LLC are independent entities. Insurance products and services are offered through individually licensed and appointed agents in various jurisdictions. Vertex Capital Advisors, LLC does not offer legal or tax advice.


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