How to minimize taxes when leaving assets to the next generation

You’ve planned well enough to be able to leave some money to your children or grandchildren. But have you thought about the tax consequences of your gift?

Tax-efficient withdrawal strategies can be helpful for people looking to spend down their assets in retirement while paying fewer taxes. It may also be beneficial to address strategies for a tax-efficient way to leave assets to your heirs—specifically income taxes (rather than estate taxes, which affect very few people). Here are two factors to consider:

1. Your heirs’ tax rates

The decision to draw from Roth or tax-deferred savings depends largely on future tax rates—yours and your heirs’. If your heirs’ tax rates are likely to be higher than yours, you may want to use assets from your tax-deferred account for spending and leave your loved ones the taxable and Roth assets. That’s somewhat different from the conventional wisdom approach, where you exhaust taxable accounts, then tax-deferred accounts, then finally Roth assets.

2. Taxable assets with gains, which can be passed down to your heirs tax-free

Under current tax law, the cost basis for inherited investments in taxable accounts is the value at the owner’s death. This is known as a “step-up in basis,” and it effectively makes gains during the original owner’s lifetime tax-free for heirs. This benefit is why you may want to hold some taxable assets as long as possible, contrary to the conventional wisdom that suggests spending taxable assets first. This can be an especially beneficial strategy with highly appreciated investments in your later years

Putting your plan into action

The right approach to drawing down your retirement portfolio may involve different tactics at different stages of retirement based on your marginal tax rate. Required minimum distributions (RMDs)—annual withdrawals that people generally are required to take from tax-deferred retirement accounts, such as individual retirement accounts (IRAs)—limit your flexibility and can affect what tactics are best in different years. RMDs must be taken once you reach age 73.¹

For example, for the years—if any—that you are in the 10% or 12% tax bracket, capital gains you realize are generally not taxed. Therefore, you might take advantage of this period to sell investments in taxable accounts. In other years, you may want to preserve taxable assets by prioritizing either tax-deferred or Roth distributions.

How would these strategies work? Let’s consider a married couple retiring at age 65.

• They have $2.5 million in assets: 40% in tax-deferred accounts, 50% in taxable accounts (with a 25% cost basis), and 10% in Roth accounts.
  
• They plan to spend $140,000 per year and would have total annual Social Security benefits of $54,000 if they claim at their full retirement age (with similar amounts for each spouse).
  
• Based on these facts, they are highly likely to leave assets to beneficiaries, who we assume will have a marginal tax rate of 28%. That is higher than the couple’s top rate even under the conventional wisdom strategy.

Because of the heirs’ tax rate, it makes sense for this couple to draw down their tax-deferred assets before death. As illustrated in Figure 1 the best strategy carefully chooses when to take those tax-deferred distributions.

• Before the couple claims Social Security at age 70 (their best strategy), they would rely on both tax-deferred distributions and selling taxable account assets. The tax-deferred distribution approach would fill certain tax brackets—the 22% bracket (year one) or 10% bracket (years two through five).
• In the next five years, after claiming Social Security but before the couple’s RMDs begin at age 75, the strategy primarily uses taxable account distributions. That allows the household to stay in the 10% bracket. During the first 10 years, the couple’s taxable income is low enough that all of their capital gains are tax-free.
• Thereafter, spending needs above the RMD level are met by Roth account distributions (until depleted) and then by tax-deferred distributions, which are depleted shortly before death. That leaves taxable accounts to meet their spending needs at the very end, and the remaining taxable account assets pass to their heirs with the benefit of the step-up.

While this strategy does not reduce taxes during the couple’s lifetime compared with the conventional wisdom strategy, it helps the higher-taxed heirs. Therefore, the after-tax legacy of the recommended strategy is 12%, or $147,000 higher than with the conventional wisdom strategy.

A few final tips and reminders:

• While Roth conversions were not part of the best strategy we found for this example, they could make sense in other situations.
• As a result of the SECURE Act of 2019, most non-spouse retirement account beneficiaries will need to draw down the account fully within 10 calendar years of the original owner’s death. That could increase their tax rates during the 10-year period. That higher tax rate should be considered in your withdrawal strategy and may make Roth conversions or tax-deferred distributions in retirement more beneficial.
• Taking large tax-deferred distributions to fund spending needs (like the couple above) can help your highly taxed heirs but incurs a significant tax burden for you.
  
• We recommend using a tax professional or financial planner and starting the planning process at least 10 years before you’re subject to RMDs.

When planning your estate and retirement income strategy, it may not be easy to predict your heirs’ future financial situation, let alone their tax bracket. Even so, it can be worth taking some time to weigh the possible income tax consequences for the estate recipients versus taxes you will pay during your lifetime. (For additional details, see troweprice.com/ withdrawalstrategiesreport)