How to do estate planning for traditional IRAs

For wealthy families, passing down a traditional individual retirement account simply transfers a big tax burden from the owner to the heirs.

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That’s why strategies such as establishing a trust, converting the holdings to a Roth IRA or using qualified charitable distributions or other philanthropic gifts could help financial advisors’ clients avoid high taxes and complicated rules, according to Ari Weisbard, managing partner at Washington, D.C.-based registered investment advisory firm Values Added Financial. 

The so-called asset location of traditional IRAs decides the difference in estate planning that — to use an example cited in an email last month from Weisbard’s firm — offers four heirs the chance to each give out roughly $250,000 worth of charitable grants through a donor-advised fund instead of paying $760,000 in combined federal and state taxes on $1 million in holdings.

READ MORE: Financial advisors are divided over this RMD tax strategy

Decision points on IRAs

At some point, advisors and their wealthy clients must consider the destination for any traditional IRAs in the estate, along with the tax situation of heirs or organizations expecting to receive them, Weisbard noted. And, unlike non-spouse heirs who are likely to be required to distribute the full holdings into their taxable income within a decade after inheritance, donor-advised funds and charities won’t incur any payments to Uncle Sam.

“The least tax-efficient assets are usually the best ones to leave to charity,” Weisbard said. “The charity is just going to get every single dollar of those, so there won’t be any income tax.”

In the wake of rules that ended the “stretch” strategy for traditional IRA heirs under the Secure Act of 2019, advisors and clients have a smaller menu of distribution strategies. But the potential tools include upstream gifting or disclaiming the inheritance. Despite the fact that they’ve been around for decades and the upfront taxes on contributions mean that any future distributions will not likely carry any further duties to heirs, Roth IRAs still represented less than 12% of overall IRA holdings at the end of last year, according to the Investment Company Institute. Beneficiaries of a Roth IRA could let the assets accrue for another full decade before liquidating the accounts, in most cases without paying any taxes in the process.

“The big lump at the end isn’t a problem for the Roth,” Weisbard said. “It’s a lot of money saved, and, if they’re looking at the estate tax, it also reduces the taxable size of their estate.”

READ MORE: Elephant IRAs: Why wealthy clients face tax risks (even with Roths)

Trusts and charitable giving

Another tactic for heirs with high income revolves around accepting the IRA through grantor trusts or other trust entities that will have tax liability after the distribution — but also the ability to delay the full transition of assets beyond 10 years. A qualified charitable distribution by the IRA owner when they’re set to begin their required minimum distributions in retirement could enable some clients to avoid the complexity and taxes on heirs entirely.

“It doesn’t get added to their income at all,” Weisbard said. “It essentially solves the RMD. It’s often better than taking the RMD, realizing the income and then getting the deduction.”

The benefactors could use qualified charitable distributions as well, rather than accepting the traditional IRA distributions and their accompanying income taxes. Varying amounts of income levels among multiple heirs or shifting yearly income among them due to leaving one job for another or taking unpaid leave for a longer period of time also affect the plans for inherited IRAs.

“They’ll often want to think about how their tax brackets today might change over the next 10 years,” Weisbard said. “It helps you delay the distribution into your low-earning years, instead of that happening during the years when you’re in your peak earnings capacity.”