If you plan to pass money onto the next generation, you must look at what types of accounts you are using, and what types of investments are in them. Why? Because they can be taxed differently when they are inherited!
 

From a tax standpoint, one the most costly types of accounts to pass on is a traditional IRA. The recipient must pay taxes on all of the money that comes out of the account at their highest marginal tax rate. Worse yet, they are forced to take a minimum amount out each year, or withdrawal the full account balance over five years. This forces them to realize the taxes regardless of how high their tax bracket happens to be that year.

On the other hand, after-tax accounts are much more favorable to inherit because they receive what is called a “step-up” in cost basis. In plain English, this means that the inheritors do not owe any taxes on investment gains that have built up in an account prior to inheritance. 

Here is an example of how this knowledge can be translated into an investment strategy: 
Lets say that John Smith is 70 years old. He pays for most of his expenses with his pension, social security, and small distributions from his IRA (which he has to take out for his required minimum distribution). He doesn’t plan on spending most of his savings while he is alive and wants to pass it along as inheritance to his kids and grandkids. John wants part of his investments to be conservative in case there is an emergency, but he wants the other part to be invested for growth in hopes that his kids and grandkids will inherit more. Half of his savings is in an IRA while the other half is in an after-tax trust account.

With the help of his financial advisor, John's trust account is invested more aggressively while his IRA is invested more conservatively. 25 years goes by and John passes on. His aggressive investments have done very well over those 25 years and, as a result, a large percentage of the investments that are being passed on are in his after-tax trust account. The unrealized investment gains that John would have had to pay taxes on in his trust account are waived and his heirs don’t own any taxes on the trust account inheritance. 

If the reverse was done (IRA being invested more aggressively and the trust account more conservatively), the IRA would have been the largest part of the inheritance, leaving his heirs with a tax bill as they take distributions from the inherited IRA account. 

 

This example illustrates how an estate planning strategy can impact an investment strategy. In this particular situation, John benefited from using different investment strategies in his various accounts. There are many factors that can impact an estate planning strategy such as your current and future cash needs, tax bracket and level of assets. Everybody’s situation is different and you should speak with a financial advisor and a CPA about your specific situation to develop a strategy based on your own financial goals, risk tolerance and timeframe for investing. I invite you to contact me to have that conversation or to address any questions or concerns you may have.