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Due to the myriad complexities found in the U.S. tax code, passing on assets to heirs isn’t always easy and that’s a big reason why estate planning is a cornerstone of holistic advisory services.
Even when accounting for the regulatory burden Uncle Sam foists upon advisors and clients, estate planning is an excellent avenue for improving client relationships. In the most bottom-line, capitalist terms, many clients want their heirs and beneficiaries – be they children, grandchildren or charitable groups – to enjoy maximum spoils. Obviously, estate planning involves mortality, but it’s not a stretch to assume a person that has passed on wouldn’t like the idea of their already taxed income being taxed a second or third time.
Robust estate planning and readying strong tax-advantaged strategies should also be viewed through the lenses of client acquisition/retention. After all, there are no guarantees that when a client passes on that their heirs will remain clients or sign up to be if they aren’t yet.
An easy, effective place to start is helping the heir/perspective client deal with inherited IRAs. Here’s a statistic confirming the validity of that assertion: baby boomers hold about four of 10 IRAs. Let’s get to work.
Inherited IRA Basics
The tax rules pertaining to inherited IRAs, fortunately, aren’t highly complex, but they’re confusing enough that the heir should talk with an advisor and/or tax professional. Some of the difficulty starts with the required minimal distributions (RMDs).
Prior to 2019, folks inheriting an IRA had 10 years in which to deplete those accounts and pay tax on those funds. However, the annual RMD has been paused for several years and that’s applicable to the 2024 tax year. That’s positive in that the person that inherited the IRA can allow a larger portion of the portfolio to potentially appreciate for a longer period of time, but it’s a double-edged sword.
“The bad news is the 10-year clock is still ticking, so you may need to withdraw even more in future years if you skip RMDs this year or have done so previously,” notes Chris Kawashima, CFP®, a director at the Schwab Center for Financial Research.
Said another way, advisors ought to convey to clients inheriting IRAs that while the RMD is paused, they still have just 10 years to liquidate the account. Waiting to do so may have the benefit of fostering asset growth, but that can result in a larger-than-expected tax bill at the end of those 10 years.
Planning Matters
Proper planning matters when it comes to inherited IRAs. Sure, it’s nice that the RMD provision has been waived, but there’s no telling when that will end. Even it’s extended for another few years, advisors should impart upon clients that Uncle Sam always gets his take. It’s just a matter of “when,” not “if.”
Overall, it’s probably best to take some annual distributions from the inherited IRA, but the client needs to strategize with their advisor because even modest distributions from the inherited IRA can have unwanted tax consequences.
“For example, if the IRA balance is large, you might withdraw enough every year to max out your current tax bracket without pushing you into the next one so that you don't wind up with an outsized withdrawal in the 10th year,” according to Schwab. “Conversely, if you expect to have lower income in a few years—perhaps because you're going back to school or approaching retirement—you may wish to take smaller withdrawals until you move into a lower tax bracket.”
Related: Stand Out: Why Advisors Shouldn’t Be Just Another Firm