If you’re like many of our clients, you’ve worked hard to achieve financial independence and you’re likely hoping to leave a meaningful inheritance to your children one day in the future. While this is a commendable goal, it often comes with unforeseen consequences that can turn what was meant to be a lasting legacy into a major tax hindrance. Here are the top two inheritance pitfalls to avoid and how you can restructure your funds to leave a tax-efficient legacy.
The Unholy Life Insurance Trinity
One of the most appealing components of life insurance is the tax-free nature of the death benefit. Not only can it be used to replace income and insure large liabilities, like mortgages, but it can also be used as an inheritance vehicle to pass wealth to the next generation. One of the most commonly overlooked pitfalls of life insurance, however, is the unholy trinity—or having three different people or entities involved in one policy.
A common example occurs when a person owns a life insurance policy on the life of their spouse and names their children as the beneficiaries. It may seem innocuous enough, but this is a tax-planning nightmare. At the passing of the insured person, the owner of the policy is deemed to have made a taxable gift of the entire death benefit to the beneficiaries. Even a smaller insurance policy with a $100,000 death benefit can quickly push your beneficiaries into much higher tax brackets. Now imagine if you had a $500,000 or $1 million policy, your wealth-building inheritance is transformed into a major tax hindrance.
The unholy trinity can be avoided if both the insured and the policy owner are the same person, or if the owner and the beneficiary are the same. Either way, it’s important to carefully review any life insurance policies with three people named.
The Downside to Inherited Retirement Accounts
Many people spend decades diligently contributing to retirement accounts with the hope that their nest eggs will last beyond retirement and potentially act as an inheritance for the next generation. Unfortunately, the SECURE Act has created new distribution rules around inherited retirement accounts (401(k), 403(b), traditional IRAs, etc.), which make it much more difficult to leave a tax-efficient legacy for your heirs.
The SECURE Act created three different types of beneficiaries for purposes of determining how distributions must be taken:
- Non-designated beneficiary: These are beneficiaries who are not people (e.g., entities, charities, trusts).
- Eligible designated beneficiary: These include surviving spouses, minor children, disabled or chronically ill individuals, and individuals who are not more than 10 years younger than the account owner.
- Non-eligible designated beneficiary: All other beneficiaries, including adult children and grandchildren.
If you are planning to leave your excess retirement funds to your adult children, they will likely be considered non-eligible designated beneficiaries (NEDBs). In this case, they will be subject to the 10-year rule, which states that NEDBs must withdraw the entire account (and pay taxes on any pre-tax funds) by December 31st of the 10th year following the account owner’s passing.
If the original account owner had already started taking RMDs from the account at the time of death, the NEDB is required to take annual RMDs in years 1-9 and fully empty the account by the end of year 10. Missed or improper RMDs are typically penalized with a 50% tax, but penalties on inherited accounts have been waived for 2020 and 2021 due to confusion over the 10-year rule. Starting in 2023, however, inherited RMD requirements (and penalties) will be enforced.
All that to say, the new inherited distribution rules significantly accelerate the tax liability of inherited funds and can put your beneficiaries in a difficult position. Proactive planning should be considered to help beneficiaries avoid a major tax pitfall.
It’s important to note that Roth IRAs are not subject to RMDs to begin with, so beneficiaries who receive an inherited Roth IRA will not have to take annual RMDs during the 10-year period. They will still have to empty the account by the end of the 10th year, but this provides a much greater window in which tax planning can be implemented. If you are considering leaving retirement assets to your children, it may be worth exploring ways to convert your pre-tax accounts to Roth.
Give the Gift of a Tax-Efficient Inheritance
If you have questions about how to structure your inheritance to avoid an unnecessary tax bill on your legacy, or if you would like a review of your overall finances, we would love to hear from you! At Horizon Planning Group, we are here to help you retire with confidence and leave a lasting legacy you can be proud of. Schedule an introductory meeting online or reach out to me at (770) 627-4157 or Scott@MyHorizonPG.com to get started.
Scott Bechely is financial advisor at Horizon Planning Group, a full-service fiduciary financial planning firm committed to always doing what’s right for their clients. Scott uses his more than 15 years of experience to help his clients create a retirement income plan that aligns with their goals and helps them live the retirement lifestyle they dream of. He believes that everyone should have a chance to obtain financial independence, and he strives to help his clients design a plan that helps them sleep better at night knowing they’re on track for their ideal future.
Scott is a CERTIFIED FINANCIAL PLANNER™ professional who graduated magna cum laude from the University of Georgia with a bachelor’s degree in business administration, focusing on finance. Outside of work, he can often be found spending time with his wife, Sara, their daughter, Anna, and their dogs, Ginger and Bailey. He loves sports and enjoys playing in his baseball league and golfing. He gives back to his community by supporting his favorite dog rescue organizations: Adopt A Golden and Golden Retriever Rescue. To learn more about Scott, connect with him on LinkedIn.
This is for educational and informational purposes only and is not research or a recommendation regarding any security or investment strategy.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP’s express prior written consent.
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