Tax Efficient Estate Planning

THIS POST HAS NOT BEEN UPDATED FOR THE SECURE ACT, WHICH WAS ENACTED IN LATE 2019.

If you have significant assets, you need an estate plan. A good estate plan makes handling the financial aspects of your death much easier for your loved ones and creates the opportunity for multiple generation wealth creation.

For most, the need for good estate plan is not about the estate tax. Very few Americans, particularly very few actively seeking financial independence, will be subject to the federal estate tax, as there is now (as of 2019) a $11.4 million estate tax exemption. Thus, only the very largest of estates will pay the federal estate tax. For purposes of this post, assume that all estates are below this threshold.

If you are aren’t subject to the estate tax, why do you need to make a tax efficient estate plan? The answer is the income tax considerations of your heirs and beneficiaries. Some assets cause your heirs and beneficiaries to have very little or no additional income tax. Other assets can cause a significant increase in the income tax burdens of your heirs and beneficiaries. Below I analyze each of the tax baskets and discuss the estate planning considerations for each one.

Being that the FI community generally aims to build up significant assets to achieve financial independence, good estate planning is particularly important if you are on the road to (or have achieved) financial independence.

A quick caveat at the beginning – tax is only one consideration in estate planning. There are many others, including the needs of spouses, children, and other potential heirs, and the desires of the donor. Below I offer thoughts on tax optimal estate planning — of course the tax considerations need to be balanced with other estate planning objectives.

Spouses

A quick note on leaving assets to spouses. Generally speaking, the tax laws favor leaving assets to spouses. A spouse is a tax-preferred heir in most situations (the main exception being leaving retirement accounts to younger beneficiaries with low RMDs). As the focus of this post is passing wealth to the second generation efficiently, most of the discussion, other than a few asides, will not address the tax consequences when leaving an asset to a spouse.

Tax Baskets

Below are the four main tax baskets (tax categories in which individuals can hold assets):

  1. Traditional (a/k/a Deductible) Retirement Accounts: These include workplace plans such as the 401(k), the 403(b), the 457, and the TSP, and IRAs. Under ideal conditions, the contributions, when earned, are not taxed but the contributions and earnings are taxed when later withdrawn.
  2. Roth Retirement Accounts: These include workplace plans such as the Roth 401(k), the Roth 403(b), and the Roth TSP, and Roth IRAs. Under ideal conditions, the contributions, when earned, are taxed but the contributions and earnings are tax-free when later withdrawn.
  3. Health Savings Accounts: HSAs are tax-advantaged accounts only available to you if you have a high deductible health plan (a “HDHP”) as your health insurance. Under ideal conditions, the contributions, when earned, are not taxed and the contributions and earnings are tax-free when later withdrawn.
  4. Taxable Accounts: Holding financial assets in your own name or otherwise not in a tax-advantaged account (tax baskets 1 through 3). The basic concept is taxable in, taxable on “realized” earnings (rental income, business income, dividends, interest, etc.) while in the account, and partially taxable (value less “tax basis”) on the way out.

Baskets 1 through 3 require “ideal conditions” (i.e., compliance with the related tax rules) to operate as outlined above. Let’s assume for purposes of this post that no errors are made with respect to the account in question.

Traditional Accounts

Of the four tax baskets, traditional accounts are often (from a tax perspective) the worst kind to leave to a spouse and the third worst to leave to non-spouse heirs. Why? Because traditional accounts, through required minimum distributions (“RMDs”), are eventually going to be entirely taxable to your beneficiaries and/or their beneficiaries. Non-spouse beneficiaries generally must take RMDs in the year following the donor’s death.

When passing traditional accounts to the next generation(s), a general rule of thumb is younger beneficiaries are better for such accounts, because the younger the beneficiary, the smaller their earlier RMDs, and thus the lower the tax hit of the RMD and the longer the tax-deferred growth.  

Spousal beneficiaries, unlike non-spouse beneficiaries, have the option to delay RMDs until the year they turn 70 ½. However, once they turn 70 ½ they will be required to take taxable RMDs, increasing their taxable income.

For charitably inclined, traditional accounts (or portions thereof) are a great asset to leave to charity. As you will see, your individual beneficiaries would prefer to inherit Roth accounts (and in most cases will prefer to inherit taxable accounts), but the charity is generally indifferent to the tax basket of an asset, because charities pay no income tax. So all other things being equal, if you have money in traditional accounts, Roth accounts, and taxable accounts, the first money you should leave to a charity should be from your traditional accounts.

Lastly, whatever your plans, you are well advised to ensure that all your traditional, Roth, and HSA accounts have valid beneficiary designation forms on file with the employer plan or financial institution.

Roth Accounts

Roth accounts are fantastic accounts to inherit for both spouses and non-spouses. While non-spouses must take RMDs from the inherited Roth account in the year following death, the RMD is non-taxable to them. All beneficiaries benefit from tax-free growth of assets while they are in an inherited Roth account. This makes spouses (able to defer RMDs until age 70 ½) and younger beneficiaries ideal (from a tax perspective) to inherit Roth accounts.

Roth conversions are a potential strategy to save your heirs income tax. If you believe your heirs will have a higher marginal income tax rate than you do, and you do not need the tax on the Roth conversion, you can convert amounts in traditional accounts to Roth accounts, pay the tax, and lower the overall tax burden incurred by you and your family.

Health Savings Accounts

There are two, and only two, ideal people to leave an HSA to – your spouse or a charity. Spouses and charities are the only ones who do not pay tax immediately on an HSA in the year of death.

Unfortunately for non-spouse, non-charity beneficiaries, the entire account becomes taxable income to the beneficiary in the year of death and loses its status as an HSA. This can cause a significant one-time spike in marginal tax rates and cause the beneficiary to lose (to federal and state income taxes) a significant amount of the HSA. This makes the HSA the worst tax basket to leave to non-spouse, non-charitable beneficiaries.

Spouses are allowed to continue the HSA as their own HSA, and thus can use it to grow tax-free wealth that can cover (or reimburse) qualified medical expenses.

If you are charitably inclined and unmarried, the HSA should be the first account you consider leaving some or all of to charity.

Taxable Accounts

Taxable accounts, including real estate and securities, are generally good assets to leave to beneficiaries because of the so-called “step-up” in basis. As a general matter, when a person dies, their heirs inherit assets in taxable accounts with a “stepped-up” basis. This gives the heirs a basis of the fair market value of the property on the date of death.

As a result, a beneficiary can generally sell inherited assets shortly after receiving them and incur relatively little, if any, capital gains tax.

A couple of additional notes. First, leaving appreciated taxable assets at death to heirs is much better than gifting such assets to heirs during your life. A quick example: William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.

Second, the step-up in basis at death benefits spouses in both “common law” states and community property states. In all states, separately held property receives a full step up in basis when inherited by a spouse. For residents of common law states, jointly held property receives a half step-up – the deceased spouse’s portion is receives a step-up in basis while the surviving spouse’s half does not. For residents in community property states, the entirety of community property receives a full basis step-up at the death of one spouse.

Conclusion

Generally speaking, in most cases spouses will prefer to inherit assets in the following order:

  1. Roth
  2. HSA
  3. Taxable
  4. Traditional

In most cases, non-spouses will prefer to inherit assets in the following order:

  1. Roth
  2. Taxable
  3. Traditional
  4. HSA

The best two tax baskets to leave to charities are HSAs and traditional accounts.

You can obtain significant tax benefits for your heirs by being intentional regarding which tax baskets you leave to which beneficiaries. Some relatively simple estate planning can save your heirs a significant amount of federal and state income tax.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.