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Strategic Bequest Planning

A reader writes in, asking:

“It has become clear that barring a market catastrophe, our portfolio will probably outlast us. We’re nowhere near the point where estate tax would be a concern, but I’ve been thinking about how to maximize the value we leave to our children.

Rather than splitting our Roth and traditional IRAs equally between our children, what do you think about leaving our Roth IRA entirely to our child who is in a higher tax bracket and leaving most of the traditional IRA to our child who is in a lower tax bracket. We would set it up so they each receive the same net amount after taxes, and this way they both get more, after taxes, than they would if we split it equally.”

If the goal is to maximize the total after-tax value of the assets you leave to your heirs, it can make sense to:

  1. Leave a greater portion of your tax-deferred assets to the heir(s) with the lowest marginal tax rate, while
  2. Leaving more Roth assets and assets that would that would qualify for a step-up in basis (e.g., appreciated stocks in a taxable brokerage account) to the higher-tax-rate heir(s).

Still, there are two potential hangups.

First, there’s simply no way to ensure that each of your heirs actually receives the same after-tax amount. Most likely, your children will be taking distributions from the inherited retirement accounts over a period of multiple years, and your children’s respective marginal tax rates will surely change over the course of those years as their income changes and as legislatively-determined tax brackets change. In addition, unless all of the accounts have the same exact asset allocation, the different accounts will perform differently prior to your death, resulting in imbalances between the amounts received by each heir.

Second, if your heirs don’t understand why you split the accounts unevenly, it could cause ill will between them (or toward you) after your death. Assuming that’s a situation you’d like to prevent, it will be critical to get the kids on board with this idea ahead of time, to make sure they understand why you’re doing it (i.e., to maximize the after-tax value to be split among them) and to make sure they agree it’s a good idea, even though it means that they will not receive identical amounts.

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