There are many reasons why estate planning is extremely important, but one of the major ones is to maximize the amount of money you’re able to pass on to your heirs after you die. While most people understand the importance of establishing a will and trusts, many forget that they should investigate ways to minimize taxes on inherited assets.
If you pass away before organizing your assets appropriately, you might be leaving a tax bomb for your kids.
What is a tax bomb?
Essentially, a tax bomb is when you or your descendants owe a large sum of money in taxes unexpectedly. This often occurs because of a sudden increase in “income” or other taxable assets. Tax bombs can be extremely burdensome, since the amount of taxes owed could be very high and unprepared for.
Tax bombs are common in a few scenarios. For the living, a tax bomb might happen after student loan forgiveness, when the forgiven portion of the loan is considered “income” that you must pay taxes on. Another very common and not often discussed scenario is when you are passing an IRA on to beneficiaries after you die. This is one situation you want to prepare for ahead of time.
When you set up a 401(k) or IRA, you put a portion of your income into a savings account to plan for retirement. While you have to pay taxes on all of your income, your IRA lets you defer those taxes. When you pull money out of your IRA during retirement, you’ll owe taxes on it then. The mandatory withdrawal amount, called a required minimum distribution (RMD), and the taxes you owe are determined by the IRS based on your life expectancy and begin at age 70.5.
When you pass away, your IRA will still hold the money you saved (plus its growth), and it can be passed down to a beneficiary, such as your child. However, taxes will still be owed on those funds.
Thus, your kids will be responsible for paying taxes on the funds passed down to them. If they decide to withdraw that money in a lump sum or roll it into their own IRA, they will owe taxes on the entire amount upfront. This is the tax bomb. If your account is substantial, the taxes owed could significantly deplete the amount of money that is actually available to your beneficiaries.
Preventing tax bombs and maximizing inheritance
Fortunately, there is a way to prevent a tax bomb from occurring, so you can maximize the inheritance your children receive. To do this, you’ll want to work with a financial advisor to set up your IRA to become what is called a “stretch IRA.”
What this does is allows your child to take RMDs after your passing, but on a schedule based on their life expectancy, not yours—meaning RMDs and taxes will be smaller. This extends the lifespan of the IRA, allowing funds to grow even more over time and your child to pay minimal taxes on the distributions each year.
It’s very important to discuss this IRA setup with a financial advisor, as well as your children, so everyone is aware of how the inheritance will work. Your financial advisor in Los Angeles can ensure the account is set up correctly, but your children will also need to understand how to access the IRA to avoid making a costly mistake. Working with a professional will ensure that everyone is on the same page regarding your assets and how to extend their lifespans for many more years.