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Billings, MT CPA Firm

Does Your Estate Plan Consider Income Taxes?


Like most people, you may have very clear ideas about the legacy you intend to leave to your loved ones. And your plans may include dividing your financial assets equally among your children, which seems to be the fairest approach. If you have four children, for example, you could leave each one of them a quarter share of your assets.

However, this approach, while seemingly equitable, may not deliver the results you hope for. The issue lies with the taxes that your beneficiaries pay. If, as is likely, your children have different marginal income tax rates, they could inherit unequal amounts after paying taxes. Furthermore, more taxes may end up being paid than necessary.

Taxes and Investment Accounts

If your financial assets consist largely of investment accounts, you know that different types of accounts, tax-deferred and taxable, have different tax implications for beneficiaries. For example, the income taxes you deferred while contributing to a tax-deferred account, such as a traditional individual retirement account (IRA), must ultimately be paid to the IRS. (State taxes may also be due.) You will pay these taxes when you make withdrawals from your IRA or those who inherit it will have to pay taxes. Essentially, your beneficiaries will inherit the income tax liability of your IRA.

The opposite occurs with a taxable investment account. With a taxable account, you pay taxes annually on any realized net capital gains, dividends, and interest earned by the account investments. When you die, your beneficiaries get the full value of the account since there is no embedded income tax liability. (For income tax purposes, the cost basis of appreciated assets is "stepped-up" to their fair market value at the time of death.)

Maximizing the Total Inheritance

As noted already, when beneficiaries have different marginal tax rates, the sum each ultimately receives is determined in part by the types of assets that are inherited. For example, let's say your estate plan states that each of your four children will receive $750,000 from your IRA, worth $3 million. If the children are in the 35%, 24%, 22%, and 12% tax brackets, each child would receive a significantly different after-tax amount.

Instead of leaving your four children an equal distribution, you and a tax professional may be able to craft a strategy that would give each beneficiary a different initial amount but nearly equal amounts after taxes are considered. Depending on the composition of your assets and your children's tax situations, this type of tax planning could also result in a lower overall tax liability.

Distributing assets unequally like this is a complex approach. Alternatively, if you have a traditional IRA, you might consider converting all or part of it to a Roth IRA. When you convert a traditional IRA to a Roth IRA during your lifetime, you incur the income taxes on your retirement savings at the point of conversion. That means that your savings can be passed on to your beneficiaries with no income tax liability. Moreover, the assets in the Roth IRA can potentially grow and be distributed free of income taxes. Again, this strategy can be potentially favorable if your beneficiaries are in different tax brackets.

When it comes to estate and tax planning strategies, we recommend that you work closely with tax and legal professionals before taking any steps.