Advisor Insight

Here's how to prepare your heirs for the $68 trillion 'great wealth transfer'

David Robinson, founder and CEO of RTS Private Wealth Management
Key Points
  • Baby boomers are set to pass to their children a mind-boggling $68 trillion — the biggest generational wealth transfer ever.
  • Much of that wealth is held in individual retirement accounts. Any mistakes in the transfer of those funds can result in a big tax bite out of that inheritance.
  • By understanding the rules before acting, heirs of IRAs can plan in ways that avoid unnecessary taxes and assure continued tax-deferred growth.
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We are entering the largest wealth transfer in history.

Over the next 25 years, according to a report from research firm Cerulli Associates, 45 million U.S. households will pass a mind-boggling $68 trillion to their children — the biggest generational wealth transfer ever.

Individual retirement accounts alone in the U.S. held more than $9 trillion in assets at the beginning of last year, according to the Investment Company Institute's 2018 Investment Company Fact Book. To that point, many Americans are inheriting substantial wealth from their parents through IRAs. But mistakes in handling these accounts could result in needlessly losing much of this wealth to taxes. In order to increase the chances of a successful wealth transfer, it's important to understand the proper steps to follow.

Any mistakes in handling inherited IRAs can incur hurtful taxes. To avoid these errors, heirs should have a thorough understanding of rules, preferably with the help of a qualified tax professional. Otherwise, they could end up paying an unexpectedly large portion of this inheritance to Uncle Sam and prematurely losing the main benefit of these accounts: long-term tax-deferred asset growth.

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The rules for non-spouse beneficiaries are more restrictive than those for spouses. Common errors by non-spouse heirs of traditional IRAs include:

  • Taking cash out too soon or under the wrong circumstances can invalidate these accounts and make withdrawals taxable as ordinary income. (For single individuals or heads of households, this tax rate is 37 percent for incomes greater than $500,000.) To avoid this hit and keep these accounts valid as tax-deferred, heirs should be careful not to touch them before transferring them directly into accounts created expressly and solely for this purpose.
  • Titling inherited IRA accounts incorrectly will be costly. These accounts must be titled with precise wording that designates them as being inherited, stating the name and date of death of the benefactor. Thus, it's clear from the title that rules for inherited IRAs apply. Transfers shouldn't be executed until the new account is correctly set up and titled.
  • Don't overlook the required minimum distributions. Owners must make these required minimum withdrawals annually, starting at age 70½. Heirs of IRAs must take RMDs in proportions based on their age. Failing to do so can trigger a painful 50 percent IRS penalty on the amount that should have been withdrawn that year. After learning that RMDs don't kick in until the age of 70½ for original holders of IRAs, some heirs mistakenly assume that this applies to inherited IRAs. If the benefactor had begun taking RMDs but had not taken one in the year of their death, heirs should be sure to take the withdrawal required for that year before transferring the account.
  • Failing to divide IRAs by having them transferred to separate accounts of multiple heirs. Benefactors may choose to split up their IRAs among their heirs, but often they don't. In these cases, it's up to heirs to do this. This is especially important if there's a significant age difference among heirs. Let's say three siblings inherit an IRA, and one is much older than the other two. If the IRA isn't split into three accounts, the age of the oldest sibling is used to determine the amounts of RMDs for all three. This could mean that the younger heirs would have to take out more money sooner than they'd like, incurring more tax. (Though no minimum withdrawals are required for Roth IRA owners, there are for heirs of these accounts, but these RMDs are tax free.)
  • Making contributions. Tax rules forbid heirs from contributing to inherited IRAs. Doing so can invalidate accounts, making all of the assets in them taxable as ordinary income. Some heirs inadvertently make contributions to their inherited IRAs that they intended for their own IRAs. This can be costly. Let's say you inherit a $1 million IRA and make a $100 contribution to it. This could trigger federal tax of $370,000 — plus applicable state and local taxes. The idea is to grow the account as long as permissible under the rules, taking RMDs and incurring taxes incrementally.
By understanding the rules before acting, heirs of IRAs can plan in ways that avoid unnecessary taxes and assure continued tax-deferred growth.
  • Assuming that creditor protections still apply. In many states, IRAs tend to be protected from creditors and bankruptcy judgments, but inherited IRAs may lose this protection. Thus, when leaving an IRA to a financially irresponsible heir — perhaps one with gambling or spending issues — one option to protect these assets is to leave it to a trust created to serve the heir's interests.

By understanding the rules before acting, heirs of IRAs can plan in ways that avoid unnecessary taxes and assure continued tax-deferred growth.

The key is to not touch the account without awareness of the consequences and to get a grasp of tax rules quickly, as various deadlines are involved. After the account is correctly transferred into a properly titled inherited account, cash can be taken out with minimal tax consequences in the form of RMDs.

— By David Robinson, founder/CEO of RTS Private Wealth Management