Madison Eubanks

Jul 26, 2024

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3 Income Tax Strategies for IRA-Heavy Estates

Traditional estate planning advice revolves around moving as many assets as possible out of the estate to minimize estate tax liability. However, most people’s estates will never approach taxability, meaning they need a different approach to estate planning. 

At the most foundational level, planning for non-taxable estates—those valued at less than $13.61 million—means ensuring clients have appropriate documents like wills, trusts, and powers of attorney in place. 

However, just because a client isn’t subject to federal estate tax doesn’t mean they can ignore tax planning. In this blog, we’ll look at tax planning strategies for non-taxable estates where the owner has significant assets in an Individual Retirement Account (IRA), and how to optimize asset transfer for beneficiaries. 

If you’re ready to dive into all things non-taxable estate planning, download the complete guide here. 

Introduction to planning for IRA-heavy estates

Beneficiaries who inherit Individual Retirement Accounts (IRAs) have a compressed timeline in which they must pay income taxes on those accounts. For example, most non-spousal beneficiaries have only 10 years to fully withdraw an inherited IRA, due to the SECURE Act which became effective in 2020. 

Often, beneficiaries inherit IRAs when they’re in their highest earning years, potentially increasing their tax rates. For example, let’s say 80-year-old Robert dies and leaves his $1 million IRA to his 50-year-old daughter, Jenn. Forties and fifties are often a person’s peak earning years and the inherited IRA layers income taxes on top of what may be the highest income tax rates Jenn pays in her life. 

Let’s look at income tax planning for a few specific types of IRAs. 

Roth IRA

While a Roth IRA is still subjected to the 10-year rule, they don’t have income taxes for withdrawals. Clients using Roth IRAs might consider the targeted amount achieved through regular or ongoing bracket top-up or deduction soak-up strategies. Additionally, they may need to adjust their investment strategy to account for the initial tax hurdle and align use of Roth funds with their preferred timelines. 

The primary benefit of these strategies is that the converted funds remain completely available until death, so prepaying the income taxes through a Roth conversion might be lower risk than a gift from a financial planning standpoint. 

Split IRA at First Death

A traditional approach is to leave the entire IRA balance to the surviving spouse, and then the surviving spouse will leave everything to the kids upon their death. However, the SECURE Act means this doesn’t always create the best outcome for the family’s overall wealth. Here’s an example of how a split IRA can be beneficial: 

The first spouse dies and leaves half of the IRA to the surviving spouse and half to the children. The children have 10 years to withdraw their portions of that first half. When the second spouse dies and leaves the remainder of the estate to the children, they get a new 10-year period to withdraw anything left by the surviving spouse. This strategy gives the children more time to draw out the income tax exposure and could meaningfully reduce their tax burden. 

Add Life Insurance

In some cases, a single life insurance policy could create liquidity for the surviving spouse. Life insurance death benefit usually isn’t subject to income taxes, and as long as it doesn’t tip the estate into becoming taxable, estate tax is irrelevant. This strategy could make the survivor more comfortable with doing a split IRA at first death strategy if they are concerned about not having enough money. Or, the survivor can use the life insurance death benefit to cover the income taxes from a Roth conversion. Either way, the survivor now has some flexibility for strategic income tax planning. For charitably minded clients, this could make it possible to leave their IRA to charity and let the life insurance payout become the surviving spouse’s income. 

For more on non-taxable estate planning, download the guide: From Income Tax to IRAs | Tax Optimization Strategies for Non-Taxable Estates.

The information provided here does not constitute legal, financial, or tax advice. It is provided for general informational purposes only. This information may not be updated or reflect changes in law. Please consult with an estate attorney, financial advisor, or tax professional who can advise as to your particular situation.