How to Minimize Taxes When Leaving Assets to the Next Generation

So you’ve planned well enough to be able to leave some money to your children or grandchildren. But have you thought about the tax consequences of your gift?

Tax-efficient withdrawal strategies can be helpful for people looking to spend down their assets in retirement while paying fewer taxes. It may also be beneficial to address strategies for a tax-efficient way to leave assets to your heirs—specifically income taxes (rather than estate taxes, which affect very few people). Here are two factors to consider:

The decision to draw from Roth or tax-deferred savings depends largely on future tax rates—yours and your heirs’. If your heirs’ tax rates are likely to be lower than yours, you may want to use assets from your Roth account for spending and leave your loved ones the tax-deferred assets. That’s different from the conventional approach, where you wait until taxable and tax-deferred accounts are depleted before spending Roth assets.

Under current tax law, the cost basis for inherited investments in taxable accounts is the value at the owner’s death. This is known as a “step-up in basis,” and it effectively makes gains during the original owner’s lifetime tax-free for heirs. This benefit is why you may want to hold some taxable assets as long as possible, contrary to the conventional wisdom that suggests spending taxable assets first. This can be an especially beneficial strategy with highly appreciated investments in your later years.

The right approach to drawing down your retirement portfolio may involve different tactics at different stages of retirement based on your marginal tax rate. Required minimum distributions (RMDs)—annual withdrawals that people generally are required to take from tax-deferred retirement accounts, such as individual retirement accounts (IRAs)—limit your flexibility and can affect what tactics are best in different years. RMDs must be taken once you reach age 73.*

For example, for the years—if any—that you are in the 10% or 12% tax bracket, capital gains you realize are generally not taxed. Therefore, you might take advantage of this period to sell investments in taxable accounts. In other years, you may want to preserve taxable assets by prioritizing either tax-deferred or Roth distributions.

How would these strategies work? Let’s consider two married couples retiring at age 65 whose heirs are expected to have different tax rates after they inherit the money:

The first column of the table below illustrates the conventional wisdom approach—withdrawing from taxable accounts first, followed by tax-deferred accounts and, finally, Roth assets. The other columns show the best strategies we found for the two couples.

As you’ll see in the table, the biggest difference between the couples’ strategies is that the first one depletes the Roth account fairly quickly, whereas the second aims to deplete the tax-deferred account. In both scenarios, the couples can preserve some taxable assets for the step-up in basis.

When planning your estate and retirement income strategy, it may not be easy to predict your kids' future financial situation, let alone their tax bracket. Even so, it can be worth taking some time to weigh the possible income tax consequences for the estate recipients versus taxes you will pay during your lifetime. For more detailed information, see our full report (pdf) about various withdrawal strategies.