For 18 years, Adrianne Yamaki, founder and managing partner of Strategic Wealth Capital (SWC), has been serving corporate executives, entrepreneurs and multi-generational families to effectively manage their financial affairs. SWC strives to develop a deep understanding of its clients, their families, and their life goals and to serve as their primary advisor, advocate and partner over their lifetimes.

Russ Alan Prince: As part of the “Great Wealth Transfer,” one common asset that elderly clients bequeath to children is rollover IRAs. Why do you believe that passing a pre-tax IRA to an adult child may not be ideal? 

Adrianne Yamaki: Inheriting a pre-tax IRA may be less beneficial than the parent intends. Not only does the inheriting son or daughter pay full federal and state income tax on withdrawals, but demographic patterns make it likely that he or she will inherit the IRA at the worst possible time when they themselves are in a high tax bracket.

First, there is no step up at death for a traditional IRA. I met with a client’s elderly mother a couple of years ago. She believed that her $3 million rollover IRA would pass tax-free to her son because her estate was lower than the exclusion limit. Unfortunately, we know that this is not the case, and that traditional IRAs aren’t stepped up. She anticipated passing $3 million to her son, and he expected to have $3 million to spend. In reality, he and his wife are high-income earners who reside in a high-tax state, and they would lose about 45% every year from required distributions to income taxes.

Secondly, the likely timeframe of an IRA inheritance is disadvantageous. Imagine a married couple working hard and saving to a 401k for 30 years. They roll these savings to IRAs at retirement, and many years later, the last spouse to pass, statistically the wife, dies at 85. Her adult children, on average, will be 55 to 60 years old when they inherit. And at what age are clients generally in their highest earning years and paying taxes at high brackets? 55 to 60.   

As an example, if you live in New York City, when you inherit a $2M rollover IRA at the highest tax brackets, you’ll keep less than 50% of the inheritance. If you withdraw, say, $200k from the inherited IRA next year and add that to your income tax base, you’ll pay roughly $74k in Federal tax and $20k in State tax

And unlike RMDs from an individual’s own IRA, inherited IRA distributions cannot be given to charity nor retained in the IRA to be passed to the inheritor’s own children. Plus, they have only 10 years to deplete the IRA, which is not a great situation.

Prince:  How should clients think about this aspect of their estate plan?  Are there better ways to handle IRA bequests? What types of strategies are you using with your clients? 

Yamaki: If the parent wants to help think through whether they are maximizing what their heirs receive, we sit down with them and work through the numbers. If the parent has two grown children, for example, and Child #2 has more modest wages and lives in a tax-free jurisdiction, giving him a larger percentage of the IRA means that the after-tax pot of money is larger, and there is more to go around. Giving Child #1 more of the post-tax assets may make more sense since income tax has been paid on those assets and may even have been stepped up to market value, which is an additional benefit because there are no embedded capital gains.

For the client with a $3M IRA, we have been tactically implementing strategies, including selective partial Roth conversions and ensuring that different family members will inherit certain assets based on their own financial situations. Another strategy we’ve used is to bequest pre-tax IRA assets to a charity and give one’s children tax-free or post-tax assets.

Fair does not always mean equal. A parent could give the same dollar amount to three children in three different states with three different tax brackets, and the outcome could be far from equal.  Spendable savings is what counts. 

Prince: What other assets may have caveats for an inheritor?

Yamaki: Other assets requiring thoughtful planning include illiquid assets such as real estate or art. Inheriting a home can come with its maintenance costs. Preparing such a large asset for sale often requires time and effort before putting it on the market, and realtor costs and other expenses may easily total over 10% of the asset value. Clients may want to consider selling some of their properties while alive to save their children from having to make such decisions after they are gone, particularly if the adult children live out of state.

In the end, an inheritance is a wonderful gift representing the giver's care, love and benevolence. At the same time, a thoughtful, planned approach can help elderly parents ensure that their many years of saving will benefit their children as generously as possible.

Russ Alan Prince is a strategist for family offices and the ultra-wealthy. He has co-authored 70 books in the field, including Making Smart Decisions: How Ultra-Wealthy Families Get Superior Wealth Planning Results.