Is it advisable to pay taxes upfront on a $1 million nest egg by ‘ripping off the bandage’?
Dear Fix My Portfolio,
I am a 74-year-old retired widower with a significant amount of money invested in tax-deferred retirement vehicles. I have been considering liquidating these funds and incurring a large tax bill in order to leave the proceeds to my children without them having to worry about paying taxes on an inherited IRA. Is this a wise decision?
Since you are over the age of 59 ½, the money you have saved in your tax-deferred accounts is for you to use however you see fit. However, it’s worth exploring what is best for your heirs in terms of both the total dollar value and ease of use for them. Leaving money to your children may seem like a simple and generous act, but inheriting an IRA comes with unavoidable tax responsibilities for the recipients.
Non-spouse heirs are required by the government to empty tax-deferred accounts within 10 years of inheritance and pay taxes on every withdrawal. This can have implications on various financial aspects such as overall tax burden, financial aid for colleges, divorce settlements, and more. While it is noble to want to make things easy for your children, it’s important to consider the potential complications they may face.
In terms of the math, it is unlikely that liquidating your tax-deferred funds all at once would be financially advantageous. With plenty of other funds available for your retirement, it is important to ensure that you can afford such a large tax payment without jeopardizing your current financial stability. Additionally, if you live another 20 years and face high healthcare costs, you may end up regretting the large payment made to the IRS.
One option to consider is designating your heirs as beneficiaries of your accounts and letting them inherit what’s there after you pass away. They can then pay taxes on the inherited funds over the course of 10 years. Another option is to convert smaller amounts to a Roth IRA over time while you’re alive. The decision depends on your current tax bracket and that of your children who will inherit.
If you are in a higher tax bracket than your heirs, it may be more tax-efficient to leave the money in the tax-deferred account and let them withdraw and pay tax on it at their own rate. On the other hand, if you are in a lower tax bracket and your children are in higher earning years, doing Roth conversions over time may be a better option.
However, it’s important to note that converting all your funds at once has its downsides. You miss out on tax-deferred growth and may end up paying more in taxes than if you smooth out your tax burden by converting smaller amounts at a time in lower tax brackets.
In conclusion, while the desire to leave your children with a tax-free inheritance is understandable, the math may not support such a decision. It is crucial to consider your current financial stability, potential future expenses, and the tax implications for both you and your heirs when making a decision of this nature.
Remember, there is no one-size-fits-all answer to this question. It’s important to consult with a financial planner or certified public accountant who can provide personalized advice based on your specific circumstances.
Beth Pinsker
MarketWatch.com
