The Best Way to Leave Assets for Non-Spousal Heirs

Although very well-intentioned, qualified plans are not the best assets to plan on leaving behind to your non-spousal heirs. The problem stems from the fact that they may be subject to income and estate taxes upon their inheritance. Depending on your gross estate value and your state of residence, your qualified plans could be subject to federal estate tax, state death tax, and federal and state income taxes.

Even if your estate is not subject to estate or death taxes, whenever the non-spousal beneficiary of your qualified plans needs to take money out, which they'll be required to take mandatory minimum distributions each year, these distributions will be taxed at their ordinary income tax rates. These required minimum distributions could possibly push the inheritor into a higher tax bracket, cause more of their Social Security income to be taxed, cause their Medicare premiums to be higher and cause a whole slew of other not-so-great events to occur.

Move Assets to a Roth IRA to Save Income Tax

The best thing to do is to understand your adult children's or other non-spousal heirs' financial situations, especially their income tax bracket. If your own income tax bracket is lower than your adult children's bracket, it might make sense for you to convert the qualified plans to Roth IRAs now. You might be in a lower bracket than your adult children, even after converting the plans, if done properly. If you are charitably inclined, you can convert qualified plans to Roth IRAs in conjunction with your charitable giving, and convert the plans virtually tax-free. Roth IRAs will be inherited income-tax-free, but could still be subject to estate and death taxes. (For related reading, see: How to Convert a Non-Dedictible IRA Into a Roth IRA.)

Put an Inheritance in an Irrevocable Life Insurance Trust

Another, more tax-efficient strategy could involve taking IRA distributions, paying the taxes (preferably in a lower bracket than your heirs) and putting some or all of the proceeds into an irrevocable life insurance trust. The trust assets would be outside of your gross estate, so protected from a nursing home, avoiding estate and death taxes, and the life insurance proceeds would be inherited income-tax-free. A second-to-die policy covering both you and your spouse will get you the highest death benefit for the amount of premium you can commit to.

Take Distributions in the Lowest Tax Bracket Possible

The main objective is to take distributions in the lowest tax bracket possible. If your adult children will be in a lower bracket even after inheriting the plans, then that can work too. However, the best assets to leave to adult children are non-qualified plans and assets held outside of retirement plans, as they generally receive a "step-up" in cost basis to the date-of-death market value, as opposed to the original owner's cost basis which could be much lower. When these assets are sold they receive the lower capital gains rates versus distributions from qualified plans which receive the higher ordinary income tax rates.

So, as you can see, there are many ways to transfer assets to heirs, however, some are more cost-effective and tax-advantaged than others. It really depends on you and your family’s particular situations and taking advantage of the differences in tax brackets, if possible. (For related reading, see: Estate Planning: Which Assets Are Best to Leave Your Family.)