Estate planning is one of the most critical services financial advisors can provide clients and their families. Yet, too many of us only do the bare minimum in this area, like working with an estate attorney, making sure titling is current and continuously updating the plan based on life events.
Part of getting beyond those prerequisite steps is pursuing smart asset location strategies to help clients make the most of their estate planning. Here’s an overview.
When it comes to estate planning, some advisors only think about how much a client should donate to charity. Equally important is which assets make up that donation.
Whether an estate writes a $250,000 check from a bank account or leaves a traditional IRA worth the same amount, the implications for the charity are the same: If it meets the IRS’ exemption requirements, it pays no taxes.
Contrast this with how the above could impact an heir. Just like a charity, individuals do not pay federal taxes on cash inheritances. But were they to inherit a traditional IRA, the distributions are subject to ordinary income rates. (They could face further complications if they fail to liquidate the account within 10 years, per the SECURE Act).
This should make it easy to understand why waiting to give qualified assets to charity is the best approach, preferable even to writing a check each year. Not only does it create added tax efficiencies for clients and their heirs, but it allows many of them to support causes that are near and dear to them.
Let’s say a client has two children, a son and a daughter, who collectively are the sole heirs to the estate. The daughter’s household income is over $500,000, while the son’s is a more modest $75,000. Let’s also say that the client has a traditional IRA worth about $1 million and a Roth IRA with a balance of about $500,000.
In this instance, the daughter should get the Roth IRA and the son most of the traditional IRA. This certainly may go against the client’s instinct to treat each child equally. But in diving deeper, we can see that despite what seems like a big difference on the surface, the two children could end up netting similar inheritances over time, thanks to traditional IRA distributions being considered ordinary income and Roth proceeds tax-free.
For the daughter, the disparity in how the IRS treats these vehicles would likely be significant since, all other things being equal, her household rate is already 35% (and could go up in coming years given President Biden’s stated intention to raise taxes on high earners). And while it’s probable the son would enter a new bracket with his added taxable income, his burden would still dwarf his sister’s if he managed the distributions strategically.
Meanwhile, sometimes clients have nothing but high-earning heirs. If that’s the case, and they have sizeable qualified account balances, advisors can seek creative ways to push the client to the limit of their current tax bracket, helping them to enjoy more of what they’ve saved and alleviating some tax burdens for their heirs.