The Balancing Act – Estate Planning for Your Heirs

25 June 2024

When we set out to plan our estates, most of us want to leave our children equal inheritances.

Easy, right? Just divvy up each of your assets in equal shares!

But, is “equal” always “equitable?” In other words, does leaving equal portions of each asset ensure equal post-tax inheritances for your children?

In some cases, the answer may be “no, it doesn’t.”

How Can Equal Not Be Equitable?

Consider the following scenario, limited to the disposition of assets held in qualified retirement accounts:

Marjorie is a 70 year-old widow. She retired 5 years ago from a successful career in technology, having amassed $5 million in retirement assets, broken down as follows:

Traditional IRAs totaling $3 million
A Roth IRA totaling $1.5 million, which assets have been held in that account for over 5 years

Marjorie has two children:

Nancy is a well-paid physician; her husband is a prosperous attorney. Together, their earned income puts them well into the 37% income tax bracket.
George is a construction worker; his wife is a homemaker who works part-time. Together, their income is just low enough that they qualify for the 12% income tax bracket.

Marjorie has designated Nancy and George as equal beneficiaries on both the traditional and Roth IRAs. Her traditional IRAs have been funded by pre-tax dollars, making distributions taxable at her beneficiaries’ ordinary income tax rates. Her Roth IRA was funded by after-tax dollars and, since the assets in that Roth IRA have been held for over 5 years, the distributions are not taxable to her beneficiaries.

Assume Marjorie passes away in 2025, with Nancy and George remaining in the same tax brackets over the 10 years they have to withdraw all their inherited retirement assets. Over those 10 years, the total tax they’d each pay, and the after-tax amounts they would each have the use of, would look like this:

Traditional and Roth IRAs Split 50/50
Nancy’s portion of traditional IRA	$1,500,000	Income tax at 37%	$555,000	After-tax amount	$945,000
Nancy’s portion of Roth IRA	$750,000	No income tax		After-tax amount	$750,000
Nancy’s total	$2,250,000		$555,000		$1,695,000
George’s portion of traditional IRA	$1,500,000	Income tax at 12%	$180,000	After-tax amount	$1,320,000
George’s portion of Roth IRA	$750,000	No income tax		After-tax amount	$750,000
George’s total	$2,250,000		$180,000		$2,070,000
Total – Nancy & George	$4,500,000		$735,000		$3,765,000

That’s $735,000 in taxes paid by Marjorie’s heirs, and George’s after-tax inheritance of $2,070,000 is $375,000 more than Nancy’s of $1,695,000, while Nancy pays over three times what George does in taxes – $555,000 versus $180,000.

But, what if Marjorie left her Roth IRA entirely to Nancy, along with $750,000 of her traditional IRA, and left the remaining $2,250,000 in the traditional IRA to George? Then, under the same assumptions, their taxes and after-tax inheritances would be:

Traditional and Roth IRAs Adjusted For Tax Brackets
Nancy’s portion of traditional IRA	$750,000	Income tax at 37%	$277,500	After-tax amount	$472,500
Nancy’s portion of Roth IRA	$1,500,000	No income tax		After-tax amount	$1,500,000
Nancy’s total	$2,250,000		$277,500		$1,972,500
George’s portion of traditional IRA	$2,250,000	Income tax at 12%	$270,000	After-tax amount	$1,980,000
George’s portion of Roth IRA	$0	No income tax		After-tax amount	$0
George’s total	$2,250,000		$270,000		$1,980,000
Total – Nancy & George	$4,500,000		$547,500		$3,952,500

This second example saves Marjorie’s heirs almost $200,000 in taxes overall. George would pay $90,000 more in taxes under this scenario than under the first, but he’ll still pay less in taxes than Nancy and the tax amounts paid by each will be similar. In addition, it brings the after-tax amounts inherited by each heir much closer to parity than under the prior example.

As you can see, it literally pays (though tax savings) to consider your heirs’ tax brackets when splitting retirement accounts as inheritances. And it can ensure your heirs get more nearly equal after-tax inheritances.

There are, of course, many other considerations that should factor into your estate planning, but they are often less tricky than retirement accounts to divide with reasonable equivalence. We have discussed many of these before, and undoubtedly will again (see below for some of our previous posts on estate planning).

We urge you to consult with your virtual CFO or trusted financial advisor to thoroughly review your assets and you estate plan in light of your heirs’ financial and tax circumstances. Some people may prefer to benefit a less well-off child more than a wealthier one, some may prefer to leave equal (or as nearly equal as possible) portions. But it’s always best to make decisions based on the most thorough understanding and information you can obtain.

If you think your estate plan might need updating in order to best protect your heirs and your legacy, please click here to email us directly – we are always here to help.

Until next time –

Peace,

Eric

For more on estate planning, see:

Is Your Estate Plan Due For a Check-Up?

Why You Need to Update Your Beneficiary Designations

When Do You Need a Trust?

The Family Meeting on Your Financial Affairs – and Why You Need to Have One

Why You Need a Financial & Estate Organizer – and What to Put in It

The Unlimited Spousal Deduction Explained

Wills and Powers of Attorney – Why You Need Both

Leverage the 2023 Estate and Gift Tax Exemptions – While They Last!