Tax Planning for a Bequest

A reader writes in, asking:

“Because of a generous pension, we expect to spend from our portfolio at a rate of just 1-2% per year, meaning that most of the portfolio will probably be left to our children. Do you have suggestions for how to prioritize our accounts for spending? Portfolio is mid six figures, so estate tax is not a concern…unless they change the rules again.”

Step-up in Cost Basis

A common piece of retirement tax planning advice is to spend from taxable accounts before spending from IRAs and other retirement accounts, so as to maximize the length of time that your money is allowed to grow tax-free. Depending on circumstances, however, that advice may need to be turned on its head when you know you’ll be bequeathing most of your holdings.

The key fact here is that when your children inherit your taxable holdings, they will receive a “step-up” in cost basis. That is, their cost basis will be the market value of the assets as of (in most cases) the date of your death. As a result, any unrealized capital gains that had built up over your lifetime will go entirely untaxed. Therefore, for taxable holdings in which you already have significant unrealized capital gains, it often makes sense to avoid liquidating those holdings and paying tax on the gain, given that it’s possible to avoid paying tax on the gain at any point in time.

The older you are — or, to be more blunt, the shorter your remaining life expectancy — the more likely it is that it makes sense to avoid selling taxable holdings with unrealized gains, because there will be fewer years in which you have to pay taxes on dividend and interest income before your heirs get to take advantage of the step-up in basis.

Your Marginal Tax Rate vs. Their Marginal Tax Rate

For most retirees, when choosing whether to spend from tax-deferred accounts or Roth accounts, the question is primarily a function of how your current marginal tax rate compares to the marginal tax rate you expect to have in the future. (If you expect a higher marginal tax rate later, it’s best to spend from tax-deferred now and preserve Roth accounts for later when you have that higher marginal tax rate.)

But when you expect to leave most of your assets to heirs, it becomes a question of how your current marginal tax rate compares to the marginal tax rate you expect your heirs to have while they’re taking money out of the accounts. If you expect your heirs to have a higher marginal tax rate than you have now, preserving the Roth account (by spending from the tax-deferred accounts) generally makes most sense.

In addition, Roth conversions can be a useful tool in years in which you find that, even after taking sufficient distributions from tax-deferred accounts to satisfy your living expenses, you still have a marginal tax rate that is lower than the marginal tax rate you expect your heirs to have when they’re taking money out of the inherited IRA.