The best accounts to leave to heirs are tax-free accounts (like a Roth IRA) and taxable accounts (non-retirement accounts). This is because your heirs pay no income tax on withdrawals.
Heirs/Charities vs. Uncle Sam
Your money can only go three places:
- You can spend it.
- You can give it away to heirs and charities.
- You can give it to the IRS by paying taxes.
At your death, give heirs and charities more, and Uncle Sam less! Leave tax-free and taxable accounts to human heirs, and pre-tax accounts to charity.
Tax-Free and Taxable Accounts: The Basics
There are three types of investment accounts: pre-tax, tax-free, and taxable.
Withdrawals from tax-free accounts, like a Roth IRA or Roth 401(k), are not subject to income tax. Neither are withdrawals from taxable accounts, like an individual or joint account.
By contrast, withdrawals from pre-tax accounts are taxed as ordinary income, which is much less favorable.
No Income Tax At Your Death
This table shows how much income tax Uncle Sam gets at your death if you leave money to your heirs.
IRS Gets At Death
Up To 50%!!!
The IRS gets nothing from your tax-free or taxable accounts at your death! So leave these to your heirs.
After Your Death
Tax-free and taxable accounts behave differently after they’re inherited. We explain below.
Tax-free accounts like Roth IRAs and Roth 401(k)s are the absolute best accounts to leave to heirs.
This is because your heirs can leave the money in the accounts to grow tax-free.
- A spouse can treat the Roth IRA as his/her own, and let the money grow tax-free until his/her death.
- Non-spouse beneficiaries (i.e., your kids) can let the money grow tax-free for 10 years. Then, they usually must withdraw it all. There is no tax on the withdrawal, but the money can’t grow tax-free anymore.
It was even better when non-spouses could stretch withdrawals over their entire lifetimes. But 10 years of tax-free growth still ain’t bad.
Taxable accounts are also good to leave to heirs. This is because most taxable accounts receive a step-up in basis at the death of the account holder. A step-up in basis means that the basis for tax purposes gets “stepped up” to the value at the account holders date of death. For example, let’s say your grandfather bought $10,000 of stock 50 years ago. He passed away, and the value of the stock on his date of death is $100,000. Because of the step-up in basis at death, your basis in the inherited stock “steps up” to $100,000. This means you can sell the stock and owe no taxes, because there is no gain ($100k sale – $100k basis = $0 gain). Real estate and other tangible property also receives a step up in basis.
During Your Lifetime
We’ve also written about ways to be charitable with taxable money during your lifetime:
- Donate appreciated stock, deduct it on your income taxes, and pay no capital gains tax.
- Bunch donations by giving 2x every other year, if you normally take the standard deduction.
If you’d like to transfer the maximum to heirs and charities at your death, and disinherit Uncle Sam, schedule a FREE Financial Pulse Assessment™. This is a 3-step process to get clarity on your finances and “test drive” our services.