New York Estate Planning & Elder Law Blog
Planning for retirement can be difficult; however, if you also plan on leaving money to heirs in your estate plan the process can be even more complex. Deciding which financial accounts should be tapped first for retirement funds and which should be left for inheritance purposes is a tricky question. The answer is often determined by your own financial needs for retirement as well as the needs of your heirs, but you can expect the following to occur with your heirs with each of these retirement accounts.
Roth IRA
As a general rule, a Roth IRA account is a great asset to leave for inheritance. When inherited, Roth distributions are tax-free for your heirs. If planned properly, your heirs can take distributions from the account over the course of their lifetimes and simultaneously leave the bulk of the principal from the account to continue to grow in interest. Additionally, the federal estate tax exemption is now at $10.6 million for a married couple. That means that most Roth IRA accounts that are inherited will be both income and estate tax free.
However, there is one issue that was recently decided by the courts regarding retirement accounts and inheritance. If your heir inherits your Roth IRA and then goes bankrupt your bequeathed Roth IRA is subject to their creditors. You should take the time to explain to your heirs that your retirement accounts are not shielded from their bankruptcy.
Stocks, Bonds, and Mutual Funds
Other types of retirement assets such as stocks, bonds, and mutual funds are good accounts to leave for inheritance if they have greatly increased in value over time. The reason for this is called the “step up” in cost basis. Cost basis is the price of an asset (like a stock or bond) when it was first purchased. This is the price that all increases or decreases in value are measured by. When you sell an asset, the capital gains taxes are determined by the amount of value that your stock or bond has increased. However, if you pass along those assets to your heirs, they get to “step up” the cost basis to the value of the asset on the day of your death. Therefore, when your heirs decide to sell the stock or bond, the tax break on capital gains will be significant.
One common idea for funding retirement, while still leaving assets for heirs, is to focus on selling stocks, bonds, and mutual fund assets that have seen the smallest gain or loss. That way the assets that will have the largest tax breaks are reserved for your heirs. Also, keep in mind when determining which assets will go to heirs that annuities inherited by non-spouses and U.S. savings bonds do not get the “step up” in cost basis.
IRA or 401(k?)
In terms of value, the costliest assets to leave to heirs are tax-deferred retirement accounts such as an IRA or a 401(k). These accounts get no step up in cost basis like stocks, bonds, and mutual funds. Additionally, they are distributed at ordinary tax rates for your heirs, unlike the Roth IRAs.
If you are planning on leaving money to your heirs as well as to charitable causes, consider leaving the tax-deferred assets to charity. Charitable organizations are not taxed on those types of assets, and the tax-free or stepped up assets can then be left for your heirs.