How Coordinating Beneficiary Designations Can Increase Your After-Tax Legacy

Three developments have made income taxes for beneficiaries increasingly important, relative to estate taxes, in recent decades.

If your beneficiaries will likely have significantly different marginal tax rates, it would increase the total after-tax estate value if lower-rate beneficiaries received more tax-deferred assets, and higher-rate beneficiaries received more tax-free assets. Typically, tax-deferred assets, such as retirement accounts, are passed via beneficiary designations (outside the will, or “nonprobate”) and may be largely taxable as ordinary income upon required withdrawal. In contrast, investments passed via estate documents (such as wills or trusts), including real estate or taxable investments, may be tax-free due to the step-up in basis. Therefore, it may seem sensible, from an after-tax inheritance perspective, to designate inheritance of your “nonprobate”, tax-deferred assets to your child who is a teacher or social worker, and your “probate,”, potentially tax-free assets to your child who is a corporate executive or doctor.

Note that for simplicity we’ll often refer in this article to wills and probate assets that are distributed via wills. However, the use of trusts, which generally avoid probate, can also be a good approach for assets that do not have beneficiary designations.

Implementing an after-tax estate planning strategy, however, has some challenges.

After initial implementation, the strategy needs to be reviewed and maintained over time, requiring a plan with flexibility. That way, the plan can still work as intended if beneficiary tax rates and asset values are different from assumptions made in the estate planning process.

This strategy makes the most sense for people whose beneficiaries will have starkly different tax rates. In addition, it is for people who are concerned with dividing their assets in a “fair” manner. Based on insights shared by estate attorneys, most people consider the “default” strategy—simply splitting everything equally without considering taxes—to be fair. Therefore, the strategy in this article aims to improve upon that approach for all beneficiaries.

Consider a situation where a parent’s estate is expected to be $1 million, evenly split between a taxable account and a tax‑deferred account. There are two children: Jennifer, who is a corporate attorney with an expected 43% marginal income tax rate (federal and state), and James, who is a graphic designer with a 24% marginal rate. The taxable account receives a full step-up in basis at death, so there are no income taxes on that portion of the inheritance. (Throughout this article, we’ll assume there are no estate taxes—just income taxes.)

If the parent divides both accounts equally (before taxes), the distribution would be as shown in Figure 1.

Clearly, total taxes would be lower if James receives more of the tax-deferred account and Jennifer gets most of the taxable account. What is a fair and practical way to do that?

First things first: What is the objective of a tax-aware estate strategy?

Previous research² on this topic points out that the common approach used above—apportioning the face value of all assets equally, without regard to income taxes—can result in inequal after-tax values to the beneficiaries. If there are any tax-deferred assets (subject to income tax for beneficiaries), a beneficiary with a higher marginal tax rate (Jennifer) will receive less, after taxes, than other beneficiaries. Those researchers suggest that this does not align with the parents’ intent to divide assets equally.

In one article (see Note 2), the proposed solution is to allocate taxable and IRA assets differently to equalize after-tax inheritance and reduce taxes paid. However, in the illustration of that solution, the beneficiary in the lowest tax bracket actually receives less after taxes than he would have received under the common approach of equal pretax division! If you were the lower‑earning sibling in that situation, you would probably consider that solution unfair, especially when you already earn less income each year than your sibling.

People can have different views on fairness in this situation. That said, several estate attorneys have suggested that, for family harmony purposes, it is usually advisable to divide the pretax estate value equally, regardless of income disparities among your children. If that’s the case, and you aren’t trying to compensate for income disparities in your estate plan, compensating for tax rate disparities on that income seems counter to the goal of fairness.

Therefore, we start with the premise that equal pretax division of assets will be considered fair by most parents and children. It’s easy to explain, and estate attorneys generally find that people don’t complain about that approach.

Solutions we describe are designed so they do not reduce after-tax inheritance for any beneficiary, as compared with the conventional method of equal pretax division across all asset types. A key objective here is “do no harm.” Put another way, we focus on improving after-tax inheritance for everyone (from a “fair” starting point), not equalizing after‑tax inheritances.

For Jennifer and James, if the goal was to equalize after-tax inheritance, the distribution would be as shown in Figure 2.

There are several concerns with this approach. First, and most glaring, is that Jennifer gets all of the incremental benefit. It doesn’t technically violate the “do no harm” rule, but James has no reason to be excited about this “improvement” over the simpler approach, especially since Jennifer already earns more income.

The second concern involves implementation and sensitivity to changes in the situation. There needs to be language in the will to apportion the taxable assets to ensure equitable treatment. Unfortunately, specifying a dollar split (like above) is impractical because the future value is uncertain. A percentage split (88% and 12% in this case) would be inequitable if the values turned out to be meaningfully different. Jennifer would ultimately receive too much if the taxable account grew and too little if it shrank.

Similarly, if the projected tax rates turn out to be incorrect, one of the siblings could be worse off after taxes than under the equal pretax division method. For example, suppose all assumptions were correct, except that James’s income situation improved and his tax rate turned out to be 28% instead of 24%. That four-point change costs him $10,000 more after taxes if he gets 100% of the tax-deferred account than if all assets were divided equally by the conventional method (as in Figure 1). He would be worse off, which violates the “do no harm” principle.

A few estate attorneys³ shared how they handle real-life situations where nonprobate assets such as IRAs are divided unequally. The method essentially has three steps:

This raises a key question: How do attorneys or financial professionals specify the tax rate when modifying nonprobate asset values in the first step? There are a few possibilities, but the one many attorneys tend to prefer is to select one “assigned” tax rate and apply it for all beneficiaries in the calculation. Continuing the example above, Figure 3 shows how the distribution would play out using an “assigned tax rate” of 33.5%—the midpoint of the two beneficiaries’ projected rates.

By using an assigned tax rate, a parent can allow both children to benefit from the strategy. Again, the goal is improvement, not equal after-tax inheritance. From a communication standpoint, this may also make the conversation with children easier—the calculation is the same for everyone, which is, in a sense, fair. And showing how it should benefit everyone certainly helps make the case that a novel approach is worth the effort.

Different assigned tax rates can enable this while still improving after-tax results for everyone. The key consideration to remember: The higher the assigned rate, the more benefit that goes to the lower-rate child.

As noted earlier, beneficiary tax rates and asset values can change. Therefore, beneficiary designations and assigned tax rates should be determined in a manner likely to prevent problems across a reasonable range of scenarios.

Tax Rate Changes

There are many life changes that can affect someone’s marginal tax bracket, including career, marital status, retirement, state of residency, etc., not to mention statutory changes. The strategy fails to improve results if the assigned rate isn’t actually between the higher-rate child’s marginal rate and the lower‑rate child’s marginal rate. Therefore, to mitigate the risk of harming any beneficiary, consider these steps:

Changes in Asset Values

This strategy relies on having some assets that pass via the will—not just assets with beneficiary designations. Those probate assets, such as real estate and taxable accounts, enable the equalization described in the approach described above.

If taxable assets represent a higher proportion of total assets at death than expected, that doesn’t present a problem. However, if taxable assets are significantly depleted relative to accounts with beneficiary designations, that could cause a major issue. There might not be enough probate assets to counterbalance the tax-deferred assets passed to a lower-rate child. Then the higher-rate child would be out of luck.

In the example above, suppose $250,000 is unexpectedly withdrawn from the taxable account before death. All other assumptions stay the same, including 100% of the tax-deferred account going to James. In this case, Jennifer ends up $17,500 worse off than she would have if assets were split by the conventional method of 50-50 before taxes. In that scenario, the plan fails the “do no harm” test.

One way to mitigate this risk is to build “cushion” into the calculation of the split in the beneficiary designation. In this example, allocating the tax-deferred account 87% to James and 13% to Jennifer (instead of 100% and 0%) would enable an equitable split. Note that the cushion has a cost: Total after‑tax value improvement decreases from $47,500 to $35,150. That’s because $65,000 of the tax-deferred account is taxed at a rate 19% higher.

In addition to building in cushion, there are other actions that can mitigate the risk of an inadequate taxable asset balance.

We evaluated the impact of this strategy for beneficiaries across many different combinations of beneficiary tax rates and asset mixes. (See information below Figure 4 for more details.)

There are two types of numbers that need to be determined when implementing this strategy. As described above, we used this method:

Figure 4 shows the dollar benefits for different combinations of assumptions. Employing the strategy improved after‑tax value to beneficiaries by 1.3% to 10.3% compared with the conventional method of dividing all asset types equally before taxes.

It is not surprising that results generally improve as the tax rate gap widens (moving to the right). It is less intuitive that results would start to tail off after tax‑deferred assets increase to beyond 50% of the portfolio. More tax-deferred assets would appear to mean more opportunity for shifting to a lower rate. Recall, however, that if there’s not enough money in other accounts to compensate, the percentage of the tax‑deferred account left to the lower‑rate child needs to be reduced.

The numbers in Figure 4 are directly scalable for different estate values (assuming the marginal tax rates are still accurate). For example, someone leaving a $3 million estate (50% in tax-deferred accounts) to beneficiaries whose tax rates are 23 percentage points apart could improve after-tax legacy by nearly $160,000 ($53,266 x 3 = $159,798). Investors need to evaluate whether the benefit is worth the effort and risks, but the potential improvement can be meaningful.

As the number of beneficiaries increases, the strategy gets harder to implement. The benefits can also be significantly smaller than for comparable two‑beneficiary cases. And if you’re not careful, a child in the middle (in terms of tax rate) could get shortchanged.

One simple way to implement the strategy for three beneficiaries is to treat the middle child like either the high- or low-rate child (whichever has the closer rate). The assigned tax rate is the midpoint between the middle rate and either the high or the low rate (whichever is further). For example, if Jennifer and James had another sibling with a 28% expected tax rate, you’d use 35.5% (the midpoint of 28% and 43%). In this example and many three-beneficiary cases, the children all benefit, but do not share the improvement equally. It can still work out, but the more beneficiaries, the more chances someone will end up disappointed.

Estate planning is complex, and this article does not address all of the factors that should be considered. However, three specific factors are worth mentioning—and discussing with a financial professional.

If you have a diversified mix of probate and nonprobate assets, and beneficiaries in significantly different tax brackets, this strategy can generate meaningful tax savings. Using information in this article, you can work with an estate attorney and financial professional to implement a plan, using an assigned tax rate in the will that is between the beneficiaries’ expected marginal tax rates. The allocation percentages specified in beneficiary designations can direct more of the tax-deferred assets to those with lower tax rates. By choosing those numbers carefully, you and your advisors can split the benefit of the strategy among beneficiaries and reduce the risk that any beneficiary will be worse off as a result of this approach.

However, this strategy does have risks and is probably inappropriate for many people. The conventional alternative is easy, and you probably won’t consider it unfair—simply allocate all accounts equally using gross (before-tax) values.

This checklist of factors can help you evaluate whether the strategy is worth pursuing. You probably want to check all or most of these boxes.

You and the professionals you rely on must also stay on top of changes and be willing to forgo the strategy if the benefits don’t seem commensurate with the risks and effort. It needs to be well documented, so that everyone involved—now or in the future--understands the strategy.

Finally, remember that the value of family harmony should not be underestimated! If this or any complex strategy threatens to cause ill will, that’s a risk you should probably avoid.