August 2023
Chris and Beau agree that a Roth IRA is the best type of account to leave heirs as money grows tax-free, and withdrawals are tax-free. Brokerage/non-retirement accounts are also beneficial, as the heir can sell shares without paying capital gains taxes on them. Traditional IRAs may not be as advantageous because distributions are taxable, and new legislative changes under the SECURE Act forces heirs to withdraw the entire balance of the account within 10 years of the original owner’s death. This may cause issues with higher tax as each sum of money that needs to be withdrawn would be higher than if the heir could take the money out over a longer period. Both Traditional IRAs and Roth IRAs are subject to the 10-year distribution rule under the SECURE Act.
When it comes to real estate, properties with high maintenance costs may burden heirs. It may be wiser to invest in real estate funds that can be passed on.
Businesses are also a potentially complex asset to leave to an heir. It is important to create a buy-sell agreement, a legally binding document that outlines how to distribute the shares of a departed or deceased partner amongst other partners and beneficiaries; this could save heirs from headaches and conflict. Another option is to consider selling the business altogether if the owner’s death is anticipated.
When it comes to Health Savings Accounts, passing it to a spouse allows tax-free use for their medical expenses. However, leaving it to anyone else could result in that account being considered income in the year it is received, thereby boosting them into a higher tax bracket. Furthermore, anyone besides the spouse cannot use the tax advantages for their own healthcare.
It is crucial to have these conversations with your wealth advisor to examine your individual situation and what makes the most sense for you and your beneficiaries.
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Watch previous episodes of THE FINANCIAL COMMUTE here:
Ep. 48 Diversifying Beyond Stocks & Bonds: Our Investment Approach
Ep. 47 Your Guide to Biden's Student Loan Debt Forgiveness: Who's Eligible
Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, joined by Wealth Advisor Beau Wirick. Beau, thanks for joining us.
Thanks for having me, Chris.
So we're here to talk about what's going on in the world. How it affects you, what you can do about it. The Fed was at Jackson Hole last week. Not that exciting. No real updates. I mean, they're going to look at housing and unemployment. But, you know, for the most part, rates aren't going down any time soon.
Yeah, they said they might even go up. Who knows what's going to happen from here on out? They're kind of trying to keep us on the edge of our seats, so we'll keep watching.
So because of that, I found an article that was somewhat interesting and talked about all these different types of accounts and assets that, you know, aren't that beneficial to inherit. I don't know about you, but if somebody wanted to leave me some assets, it might take a little bit of work, but I'm not going to complain too much about it.
Yeah, that's not an order that you send back to the chef too often, right?
I think that this article brings out some really good points. There were some legislative changes that caused some of the tax deferred accounts to not be as optimal compared to other things. And I really think that that's what the article was saying before we kind of get into those different types of accounts or assets, let's just talk high level about what those estate tax numbers are.
So for an individual, your number is 12.9 million. For joint filers, it's 25.8 million. So as long as your estate is not above that 12.9 or that 25.8, your estate is not subject to estate taxes.
That's right. And people sometimes get estate taxes confused with other types of taxes, which we're about to talk about. But as far as the ability to leave assets to your heirs, you don't get taxed on that until you hit that 26ish million threshold. And then after that, it's about 40%.
Yeah, the tax rate is about 40%. And that's somewhat important to this. And in 2026, we're going to roll back to that 6.4 in that 12.8 number. So we're talking about the estate tax there. But there's something different with the article with regards to inheriting an asset and whether or not it's optimal for you to inherit, which is what I think it was really trying.
to say. Yeah, exactly right. This isn't a conversation that you necessarily want to go have with, say, your parents by knocking on their door like, Mom, I just want you to know that I have a few conditions about inheriting these. I'd like it to be tax efficient. That being said, we as financial planners do get to have that conversation and we do have that conversation pretty regularly.
One of the pillars of financial planning is estate planning. So, for example, let's say that you have a few different options of the types of accounts that you want to leave to your heirs. If you had the choice, the best type of account to lead your heirs would be a Roth IRA. Why is that?
Well, I mean, the money that goes in there grows tax free and the withdrawals are tax free.
Exactly. So your heirs get to take all of that money after all of the growth. They get to take all that money and not pay taxes on it. Okay. And then you have a typical brokerage or trust account that, you know, it passes to them with the state tax laws and then they get taxed on it.
What's nice about the brokerage accounts, any non retirement account, is that in most cases upon the passing, the heirs get a step up in basis meaning your parents or grandparents might have bought Apple at a dollar and it's worth you know 500 today. If you inherit Apple your cost basis is going to go from that $1 purchase price to the five under the date that Apple is trading at on the date of that passing.
So the step up in cost basis is really beneficial. And that's kind of what we're talking about when you're comparing some of these.
Exactly. And so you get to sell that share of Apple and pay no capital gains taxes on it. So the third option would be a tax deferred account. This is like your 401ks, your IRAs, your 403bs. And there's a little bit of complication on that because when you pass on a tax deferred account to a non spouse, to an heir, they have to take that money out of that account over a ten year period.
Okay. Well, that doesn't seem too complicated. But one of the things that we try to analyze with clients is, are your kids going to pay a higher tax bracket on those funds when they withdraw them than you would? And this is not a science. This is kind of an art. So here are some issues that could come up.
Let's say that you're a retired individual. You're in your late seventies or early eighties and your income isn't that high. But if you passed away right now and your assets went to your son or your daughter, what if they're a high earner, they're in the 35% tax bracket or say, you live in Florida, you don't pay any state taxes, but your kids live in California, they're going to pay 13% income tax.
When they withdraw that, those assets are going to get taxed at a higher rate when they're taken out of that account, depending on who takes them out.
And you know, not to be not to make it about me or inheriting things but if you just put it on my plate and said, Hey Chris, you got the choice to inherit a non retirement account or an IRA, which one are you taking considering the values were equal, I'm going to say the non retirement account. So I get this step up in cost basis.
I can sell those assets without having to pay any taxes as opposed to the retirement account. I'm now forced to drain that over a ten year period and pay all these taxes every time. It's funny, I was just talking with a client the other day about this and it might make sense for them to start withdrawing out of their retirement accounts today to build up those non retirement accounts.
And even as they're looking at their estate plan, when they're looking to gift money to charities at the end, they're looking to give the IRA, part of the IRA to charities because charities aren't subject to that tax. So there's a lot going on here in tax deferred accounts. They're not as beneficial to inherit because this new law changes other things.
But I'm sure the people inheriting it will still be still be pleased.
With all of these estate planning topics, it's kind of like going to an orthodontist. It's something that you need to do, but it doesn't feel good to talk about what happens when you pass away.
The interesting one that I saw in the article was about real estate, right? And, you know, we do a lot with regards to investing in real estate. And I know that a lot of people build their wealth with real estate and the points that this article made was if you've got real estate with high maintenance costs and then your heirs inherit this property or these assets, if it's not inherited in the right structure or gifted over time in the right way, all of a sudden, the property gets reassessed for property taxes, high maintenance costs.
It may not be as good of an investment as it once was. And even if let's just say that it is done the right way after a couple generations, there's now potentially 10 to 15 different owners of these assets, all with different needs and wants. And are they going to be on the same page? That's why investing in a fund type structure can be so much easier.
People can, you know, receive their portion of the fund, get a step up in cost basis, not have to deal with what did you mentioned to me earlier, the three Ts.
Toilets, tenants and trash.
They don't have to deal with the maintenance and operating costs, but they can own their their share. And then as that winds down, they can do what they want with those proceeds. So I thought real estate- that's a, you know, one of those assets that people look at how to build generational wealth.
Real estate can be a great way to build generational wealth, but it can be a challenging asset to inherit.
And like you said before, all else being equal, if I had my choice on whether or not I wanted to inherit a real physical building that I have to maintain and deal with the tenants, trash and toilets, or if I could inherit a managed fund of diversified real estate where I don't have to do anything except cash checks, I'm going to choose the latter.
I like the idea of being a passive investor, all else being equal. And so I think one of the things that we run into a lot with our clients is that they inherit properties, but they have to share the ownership with their siblings or their cousins or something. And there's just a lot of complexity with that when you have to make decisions with other family members.
And so having real estate in in funds that is fungible, that can be divided, you know, among heirs, it's a lot cleaner because then your heirs get to decide what they individually want to do.
Yeah. And it's just worth having a conversation with us and potentially your estate planning attorney around this. You know, what is your goal? I think Warren Buffett is quoted by saying, leave your kids enough to do whatever they want, but not enough to where they do nothing. And so if that's the purpose, if many people have that same purpose, that they want their kids and grandkids to be able to live a life of fulfillment, to be able to do what they are passionate about, if they want to be an artist or a teacher or a fireman, whatever it may be, it may be more beneficial for them to inherit something that they can cash out and use those proceeds, you know, to help fund their lifestyle or education for their kids or their grandkids as opposed to a fractional share of ownership of a building.
I completely agree. And so and that brings us to a couple of other assets that might be complicated to receive, one of those being businesses. So let's pretend that your business is to be a real estate mogul, but your business is your business that you go there every day and you work on it and you're the expert on that business.
Well, a poorly known statistic is that 50% of the exits from those businesses are not planned and they happen because of death, divorce, disability, disagreement and sure, other things. I mean let's say that you and I had a business together and that we are both, you know, key, key business owners.
Well, if something happened to me then you would find yourself and we didn't have any succession plan. You'd find yourself in business with my wife, Daniella. She's great, she's fantastic. But maybe she doesn't know anything about the operations of the business. And so if we didn't have an agreement on what would happen if something happened to me, maybe Daniela steps in and she has different ideas than you on how to run it.
Some pretty negative implications on the viability of the business.
Oh, definitely, without a doubt. I mean, inheriting a business with complex parts, supply chain, operations, management with no succession can be, you know, a very stressful or difficult thing to manage while you're, you know, dealing with the loss of a loved one or a family member.
And you're dealing with the loss of a key manager to talk from the business side of things. So one thing that we advise business owners to do is one of the tactics is called a buy sell agreement. And so if something lives in the same example, something happened to me, the buy sell agreement between you and I would mean that you are able to buy out my portion of the business.
You get the first right of refusal and then you fund that with, say, a life insurance policy that's valued enough that has a death benefit that's high enough to buy my half of the business. So we advise business owner clients on this, make that process clean because you, Chris, are going to have enough to deal with trying to revamp this business, losing your partner.
You need to have some liquidity. You need to have some cushion in that.
Yeah. And I'm sure Daniella, if she was to lose you, she wouldn’t want to deal with this.
About that highly levered assets and timeshares, These can be problematic. I mean, anything that's highly levered, your profitability can change overnight. I mean, just think about real estate that was highly levered at low interest rates and now those are resetting higher interest rates this year. I mean, it's only been a year and a half timeframe. Most estates, it could take up to that long to settle them anyways.
The dynamics of how real estate has changed in value over the last call it 6 to 8 months is amazing. So anything with the high amount of leverage is just dangerous to inherit.
Yeah, and just to use kind of layman's term for that, if you have an asset that you've borrowed a lot of money in order to purchase or maintain and we call that leverage, you're able to buy more than you otherwise would. So a highly levered asset, an example would be real estate that has a lot of debt on it, or a brokerage account that has a lot of margin taken out like that's been borrowed on it.
It's just not the cleanest asset to inherit as an heir.
And then timeshares. There's people on two sides of the cap. Some love them. Yeah. Some don't like being forced to use that. Your kids may or may not feel the same way, so you might want to look at either selling those or gifting those away.
They come with maintenance costs. Like all of a sudden I've lost my parents and now I'm getting, you know, a $2,000 bill every year for this timeshare. Like, what is this? I don't want this.
So what are the interesting ones was Health Savings Accounts.
Yeah. And so with an HSA if you're leaving it to your spouse nothing happens. You know if Daniella gets my HSA when I pass away, it's hers. She's able to still take that money out tax free when she uses it for medical.
Okay, so, so, so with a spouse they still get all of the tax benefits, but they can take the money out. And, you know, as long as it's qualified medical expense, they pay no tax on the withdrawal. And if they are over the age of 65, they can take it out for any reason and they just have to pay income taxes like they would an IRA.
Yeah, it's as though it's their HSA that they've had the entire time. But those rules change if you leave it to someone else, you can leave it to a sibling. You can leave it to another family member, to your kids. If you do that, if they're the beneficiary of your HSA, well, they get taxed for ordinary income tax on that amount.
They're required to pull out the entire account balance and pay ordinary income tax. So let's say you have, I don't know, let's use a larger number, $100,000 HSA- you leave it to your kids and they're already making $500,000 a year. They're in a high tax bracket.
They have a successful kid.
Exactly.
And so they're going to take a $100,000 ordinary income disbursement. They'd have to pay about 50% tax.
That's fascinating. I mean, health savings accounts are often something that, you know, we don't think of the forefront when we're having these conversations. But that's a perfect asset that goes to your spouse first and then potentially a charity or an organization the second, because it's not likely that you're going to have a health savings account that's worth several million dollars or even, you know, several hundred thousand dollars.
They're relatively new instruments and people are learning how to use them right out.
Right. And you tend to withdraw from them a lot more than you would another tax deferred account, like a Roth IRA or something. You're using it as you go. So like you said, when you're over the age of 65, you can actually pull out funds from your HSA for any and all reasons. And so it's something to consider, tax-free.
It might be better than leaving that to your kids.
But there's been a fun conversation around life, legacy planning and inheritance. At the end of the day, you know, please schedule a time with your mom and wealth advisor and have these conversations about what you own, who you want it to go to and what your ideal plan is. And we can figure out what makes the most sense for you.
Disclosure: Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your financial, legal, and tax professionals before implementing any transactions and/or strategies concerning your finances.
