Retirement spending with heirs in mind
Joel Dresang: Dave, a lot of retirees, even of moderate means, don’t go through all of their wealth in their retirement. So how should investors approach retirement spending if they expect to have money to pass along?
Dave Sandstrom: Joel, three things. Number one, plan ahead, something that we always recommend when dealing with financial decisions. Number two, understand the tax implications in the current retirement accounts that you have as they occur when you spend. And then, just as importantly, understand the implications of how they pass through your estate and how your heirs are going to be taxed on those accounts.
Joel: So, retirees would have different spending strategies depending upon whether they’re expecting to pass money along?
Dave: Absolutely, Joel. So, if we’re talking about having a balance left over that we want to pass to the next generation, it’s important to take into consideration what is my tax bracket, versus what my heir’s tax bracket is. Because that could have some pretty significant implications on what do I spend now – out of which account, versus which accounts go on to my beneficiaries.
Joel: So, let’s talk about some of those accounts. We’ve got the traditional IRA, or individual retirement account; the Roth IRA; and the taxable account, or a brokerage account. How do those considerations change in each of those? And let’s start with the IRA.
Dave: So Joel, the traditional IRA, we’re using money that we’ve never paid taxes on. So it’s a pre-tax investment. We’re allowed to let that grow through retirement, and then our withdrawals are taxed – every dollar that comes out – at our income rate. When that passes to our heirs, it’s taxed at their income level.
Traditional IRAs are subject to required minimum distributions along the way. That doesn’t change when it passes through the estate. The person that inherits that account will also be subject to required minimum distributions.
Joel: What about Roth IRAs?
Dave: So, Roth IRAs are money that we pay taxes on prior to investing it. It’s allowed to grow tax-free for us throughout our investing careers. It also remains tax-free as it passes through the estate to our heirs. There are no required minimum distributions for us when we’re alive. However, when it does pass through to the heir, they will be required to start taking distributions. They still remain tax-free, but the distributions will need to begin and continue throughout their lifetime.
Joel: And then what about taxable accounts?
Dave: So, taxable accounts, money again that we’ve paid taxes on. We invest it into an account. The growth is then taxed at capital gains rates. No required minimum distributions for us. When it passes through out estate to our heirs, no required minimum distributions in that instance. And I think the real benefit to that is your heirs will receive, in most cases, a step-up in basis, so effectively passing tax-free through the estate to our beneficiaries.
Joel: Explain that a little further: a step-up in basis.
Dave: Well Joel, in a taxable account, typically what happens is that when you sell an asset during your lifetime, you have to look at what you paid for the asset and then the value of it upon the sale, and that difference – that potential capital gain – is what’s taxed. Current tax law allows us to, when we pass away, step-up that cost basis to a value that’s established at the time of our death. And essentially, what that does is it eliminates a gain, so that you can pass that asset on to your heirs tax-free.
Joel: You mention taxes a lot in all of these accounts. Uh, you recommend that investors get professional tax help.
Dave: Absolutely, Joel. I think we’re talking about things that require some help from a professional tax person. Understand the tax consequences of your withdrawals while you’re alive. Just as importantly, understand the tax consequences that will fall on your heirs when they start withdrawals. This can get complicated, and the consequences can be very expensive.
Retirement requirement: Distributions, a Money Talk Video with Dave Sandstrom
Safe investment withdrawals for retirees, a Money Talk Video with Art Rothschild
Retirement investing: Where to begin, a Money Talk Video with Kyle Tetting
When should I …take my required minimum distribution? by Chris Evers
When Should I …check my beneficiaries?
FAQs about RMDs, from the IRS
Selecting Retirement Payout Methods, from the Financial Industry Regulatory Authority
Distributions from Individual Retirement Arrangements (IRAs), from the IRS
A required minimum distribution calculator for determining retirement account withdrawals, from the Financial Regulatory Authority
(initially posted Jan. 26, 2018)