Better to leave qualified or non-qualified money to kids?

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
Post Reply
Topic Author
pele218
Posts: 5
Joined: Mon Feb 03, 2014 10:33 pm

Better to leave qualified or non-qualified money to kids?

Post by pele218 »

I have been talking with an estate planning attorney regarding a particular situation. Let's assume I have roughly $1 million of non-qualified assets and roughly $1 million of qualified assets when I pass. I have three children and want to give 25% of either the qualified money or non-qual money to charity when I pass. For the purposes of my children being able to "stretch" the IRA money via yearly RMDs, I would assume to give them all of the qualified money and then give charity 25% of my non-qualified money. However, I also know that I can give 25% of the qualified money and no one ever pays income tax on that portion (the kids would get the remaining IRA money and be able to "stretch" on what's left). The kids would then inherit the non-qual assets at a stepped up basis and owe no income taxes on that money. The attorney is recommending to leave 25% of the non-qual assets to charity because of the ability of the IRA assets to continue compounding tax-free for the kids. Seems to make sense... Anything I'm missing here? Thank you for your help!
kaneohe
Posts: 6786
Joined: Mon Sep 22, 2008 12:38 pm

Re: Better to leave qualified or non-qualified money to kids

Post by kaneohe »

You'll have to refine the calculation but If I were the kid, I think I'd pick the taxable account.

1)Inherit 100 in IRA . Assume you didn't have to take RMDs (you do) and the value doubles in N yrs to 200. If they then take this out at 25% tax of 50,
they get left w/ 150.
2)Inherit 100 in taxable w/ stepped basis. Invest in low cost index funds. The value nearly doubles in the same N yrs. (need to adjust for drag caused by dividend taxation).
Now sell w/ 15% LTCG tax of 15 leaving you w/ 185 which is > the after tax IRA.

The TIRA is usually considered better than the taxable because you get the tax break going in and the tax deferral. In this case the kids don't get the tax
break going in and everything coming out is taxed at ordinary rates. The taxable gets the stepped up basis and LTCG rates.
bsteiner
Posts: 5682
Joined: Sat Oct 20, 2012 9:39 pm
Location: NYC/NJ/FL

Re: Better to leave qualified or non-qualified money to kids

Post by bsteiner »

The best way to view a traditional IRA is that it's part the government's (the tax rate) and part yours (1 minus the tax rate), and the income and gains on your part are tax-free.

You've correctly analyzed this. The taxable account gets a stepped-up basis at death, while the traditional IRA doesn't. However, the beneficiaries can stretch the IRA out over a long period of time, during which the income and gains on their share of the IRA are tax-free. Depending on their ages, one or the other might be more valuable.

Of course, using the IRA to provide for charity has the advantage of being simpler.
User avatar
Flobes
Posts: 1439
Joined: Tue Feb 16, 2010 12:40 am
Location: Home

Re: Better to leave qualified or non-qualified money to kids

Post by Flobes »

When we inherited IRA, my sister chose to take her share in cash because she didn't want an annual hassle. In the highest federal tax bracket, in a high tax state, she ceded nearly half. The rumble you hear is my father rolling over in his grave.
john94549
Posts: 4638
Joined: Tue Jul 26, 2011 8:50 pm

Re: Better to leave qualified or non-qualified money to kids

Post by john94549 »

As a general rule, you would prefer to have heirs inherit assets with a step-up in basis. The rule suggests you harvest all tax-deferred while alive to cover your living expenses in retirement, leaving taxable "assets" intact, so far as possible.

This is exactly our estate plan.
User avatar
Watty
Posts: 22178
Joined: Wed Oct 10, 2007 3:55 pm

Re: Better to leave qualified or non-qualified money to kids

Post by Watty »

Anything I'm missing here?
I'm not a lawyer and it might vary with your state laws, but with an inherited IRA the kids might have less problems keeping it separate if they ever divorce. If they inherited cash instead and then did something like used it to pay off a their house or to fund their retirement accounts then if they get divorced how to split the money would be much more complex.

If you want to split the money equally four ways then you might want to adjust the money for the different taxes that will eventually be paid.

For example if you had $400K with $100K in cash and $300K in IRA's that will go to the kids someday then if they will likely be in the 25% tax bracket there will be $75,000 that will eventually be paid in taxes. In effect each of the kids will be only be getting $75,000 since $25,000 of the IRA is differed taxes. The charity would be getting the full $100K in value.

The ratios of how much you have in the retirement accounts and the taxable account will change over the years and you may have some large expenses during your final years of life. It would be very rough, but leaving one fifth(before taxes) of the estate to the charity might be closer in value to one quarter of the value of the estate after taxes are adjusted for.You might want to just leave one fifth of the cash and IRA's to the charity, Roths would be best left to the kids.

bsteiner wrote: However, the beneficiaries can stretch the IRA out over a long period of time, during which the income and gains on their share of the IRA are tax-free.
Unless it is a Roth it is tax differed and not tax free and they will be having to take RMD's from the inherited IRA while they may still be working.
User avatar
grabiner
Advisory Board
Posts: 29543
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Better to leave qualified or non-qualified money to kids

Post by grabiner »

If your kids are not maxing out their own retirement accounts, or have a lot of debt, it may be better to leave them non-qualified money.

If you inherit $100K in a taxable account and use it to pay down your mortgage, you get the benefit of the full $100K with no tax cost. If you use it to contribute an extra $10K per year to your Roth 401(k), or $13,333 per year to your traditional 401(k), and the remaining amount grows to $120K before you move it all, you will lose only $3K to taxes on the dividends and capital gains.

If you inherit $100K in an IRA and use it to pay off your mortgage, you lose $25K to tax, so you can only pay down $75K of your mortgage. If you use it to contribute to your Roth 401(k), you lose $25K plus any gains. If you use it to contribute to your traditional 401(k), you can contribute the full $100K ($120K including growth); the tax deduction cancels out the tax savings on the 401(k), but that still isn't as good as starting with taxable money.
Wiki David Grabiner
Bill M
Posts: 438
Joined: Sun Dec 30, 2012 10:10 pm

Re: Better to leave qualified or non-qualified money to kids

Post by Bill M »

For the qualified assets, the answer depends whether they are pre-tax, after-tax, or Roth. Inherited a Roth account means the entire balance can be withdrawn tax-free, so 100% to the kids. A traditional IRA with basis means some portion is withdrawn tax-free, and the remainder is withdrawn as you stated for qualified accounts.

So I would say the preferred order (from the view of an inheritor): Roth accounts, non-qualified accounts, pre-tax qualified accounts. A qualified account with basis would come ahead of non-qualified if the basis is over ~85% of the value, or after non-qualified if basis is less than ~85% (basis being ~85% is roughly where the ordinary income tax would match the capital gain tax on non-qualified accounts).

Note that this leads to a slightly different ordering of tapping the accounts for the retiree.
User avatar
celia
Posts: 12400
Joined: Sun Mar 09, 2008 6:32 am
Location: SoCal

Re: Better to leave qualified or non-qualified money to kids

Post by celia »

grabiner wrote:If you inherit $100K in an IRA and use it to pay off your mortgage, you lose $25K to tax, so you can only pay down $75K of your mortgage. If you use it to contribute to your Roth 401(k), you lose $25K plus any gains. If you use it to contribute to your traditional 401(k), you can contribute the full $100K ($120K including growth); the tax deduction cancels out the tax savings on the 401(k), but that still isn't as good as starting with taxable money.
The part I underlined is NOT true. You cannot rollover money from an inherited IRA into your own. You must first take the distribution, pay the tax, then the remainder can be contributed to your own IRA. I suppose you could say that the contribution (if that large a contribution is allowed at the time you die) is allowed, but 25K (or whatever the beneficiary's tax rate is) would have to be paid from other sources.

My take is that you should give 1/4 of the qualified funds to charity as they will not have to pay taxes on it. They can keep the whole amount, whereas individuals will have to pay taxes.

Knowing that a dollar in a Roth is worth more than a dollar in taxable accounts (since the tax on the Roth was paid when the contribution was made and taxable accounts have only growth that is taxed each year) and knowing that a dollar in taxable accounts is worth more than a tax-deferred dollar (as taxes haven't been paid yet), which asset would YOU prefer to get? Even though you can stretch withdrawals on the qualified account while the account grows, your beneficiaries will still only get 75% of it (assuming the 25% rate still applies every year). The value of the account can double, but 25% of the increased value will still be lost. The same amount of money in taxable can also double in the same time, but only the growth (1/2 the value of the account) is taxed spread out over the years, not the whole account. And capital gains may continue to have lower tax rates.

Then you have the probability that your children could likely be in different tax brackets when they withdraw. If they all withdrew the same amount each year, they will be left with different spendable amounts after taxes are paid.

Another thing that hasn't been mentioned is the estate tax. If you have a large estate (over the amount that can be passed down tax-free), tax-deferred investments will be tallied up in your estate to calculate the estate tax. While your estate only owns 75% of those assets (the govt owns 25%), they will have ESTATE TAX calculated on 100% of their value.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.
User avatar
celia
Posts: 12400
Joined: Sun Mar 09, 2008 6:32 am
Location: SoCal

Re: Better to leave qualified or non-qualified money to kids

Post by celia »

Flobes wrote:When we inherited IRA, my sister chose to take her share in cash because she didn't want an annual hassle. In the highest federal tax bracket, in a high tax state, she ceded nearly half. The rumble you hear is my father rolling over in his grave.
If she is already in/near the highest tax bracket WITHOUT taking any distributions, this certainly makes sense to me.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.
kaneohe
Posts: 6786
Joined: Mon Sep 22, 2008 12:38 pm

Re: Better to leave qualified or non-qualified money to kids

Post by kaneohe »

celia wrote:
grabiner wrote:If you inherit $100K in an IRA and use it to pay off your mortgage, you lose $25K to tax, so you can only pay down $75K of your mortgage. If you use it to contribute to your Roth 401(k), you lose $25K plus any gains. If you use it to contribute to your traditional 401(k), you can contribute the full $100K ($120K including growth); the tax deduction cancels out the tax savings on the 401(k), but that still isn't as good as starting with taxable money.
The part I underlined is NOT true. You cannot rollover money from an inherited IRA into your own. You must first take the distribution, pay the tax, then the remainder can be contributed to your own IRA. I suppose you could say that the contribution (if that large a contribution is allowed at the time you die) is allowed, but 25K (or whatever the beneficiary's tax rate is) would have to be paid from other sources.
I read grabiner's comments differently. He is talking about contributing (not rolling over) to a traditional 401K, not an inherited IRA. He is also assuming (see earlier in that same post) that the 401K is not being funded fully . If you do the inherited qualified plan withdrawal in the same year as the 401K contribution, the inherited withdrawal adds to taxable income but the 401K contribution makes for a lower taxable earnings so they cancel each other out. The net result is that funds move from inherited to 401K.
rustymutt
Posts: 3986
Joined: Sat Mar 07, 2009 12:03 pm

Re: Better to leave qualified or non-qualified money to kids

Post by rustymutt »

Flobes wrote:When we inherited IRA, my sister chose to take her share in cash because she didn't want an annual hassle. In the highest federal tax bracket, in a high tax state, she ceded nearly half. The rumble you hear is my father rolling over in his grave.

It might be that she needed that money right a way to be happy and stress free. Just guessing that.
Even educators need education. And some can be hard headed to the point of needing time out.
randomguy
Posts: 9210
Joined: Wed Sep 17, 2014 9:00 am

Re: Better to leave qualified or non-qualified money to kids

Post by randomguy »

I think getting 1 million in cash versus 1 million in an tIRA is a no brainer given the odds are you are paying 15-25%+ in taxes on the way out of the IRA. It is unlikely that tax deferral can make up for that. For me the order is ROTH>Taxable>tIRA. Now if you offer 20% more in a tIRA than in taxable or a ROTH, it becomes an interesting choice.

The real question is can you leave more money by doing things differently. For example what happens if before you die, you donate 250k of taxable and then convert 250k of your tIRA for your kid (avoid RMDs, a lot of advantages to stretching out an asset with a 0% tax rate)?
User avatar
celia
Posts: 12400
Joined: Sun Mar 09, 2008 6:32 am
Location: SoCal

Re: Better to leave qualified or non-qualified money to kids

Post by celia »

kaneohe wrote:I read grabiner's comments differently. He is talking about contributing (not rolling over) to a traditional 401K, not an inherited IRA. He is also assuming (see earlier in that same post) that the 401K is not being funded fully . If you do the inherited qualified plan withdrawal in the same year as the 401K contribution, the inherited withdrawal adds to taxable income but the 401K contribution makes for a lower taxable earnings so they cancel each other out. The net result is that funds move from inherited to 401K.
My point was that any withdrawal from the inherited qualified tax-deferred plan is taxed, regardless of what it is used for.

Even though you might still put the same amount that was withdrawn from the inherited tax-deferred account into a 401k, 403b, or other tax-deferred account, taxes will eventually be owed. If you withdraw 100K and contribute 100K, you have the same taxes that year as if neither action was taken. I agree. But eventually taxes will be paid on that 100K when it is withdraw from the beneficiary's 401k. I guess it's more like extending the "stretch".

I have heard stories of people who tax-deferred too much income and their RMDs were way more than they needed (especially after the account grew). So the RMDs were taxed at very high tax rates. If the OP's kids are minors, it would be impossible to know what the laws and their kids' tax rates will be when they turn 70 1/2. The OP may not even be 70 1/2 him/herself!
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.
MN Finance
Posts: 1834
Joined: Sat Dec 22, 2012 10:46 am

Re: Better to leave qualified or non-qualified money to kids

Post by MN Finance »

Some of this clearly depends on the beneficiaries use of the funds, but there is virtually no possible scenario where it would be better for the kids to inherit the IRA. Mathematically calculating it would take some work, but they start out behind by the amount equal to their tax rate, come out behind by having growth at ordinary income rates, only to have the small advantage of compounding the annual dividends and interest. No way this is even a question.
Post Reply