Are You Leaving Your Beneficiaries a Tax Time Bomb?

The following is a guest post from Brett Sause, an 18-year veteran of the financial services profession. Brett is CEO of the Atlantic Financial Group, LLC;  and has been awarded both the National Quality Award and the National Sales Achievement Award from NAIFA.

When it comes to retirement – and to passing on whatever wealth you’ve accumulated to a spouse or the next generation – you may think you’ve thought of everything.

Understanding the Tax Implications

But despite your careful planning, it could be that Uncle Sam will be handing you a hefty tax bill while you’re living – or your beneficiaries one when you die.

Even people who have been great about saving for retirement don’t always realize the tax implications of what they’ve done. They may have created a significant tax problem for themselves, and they could be leaving behind a tax time bomb for their beneficiaries.

The scenario is a fairly common one, especially for baby boomers in or near their retirement years.

Someone told you to get an IRA or they told you to open a 401(k) because your employer was offering it as a benefit, and it sounded like a good idea. And those are good ideas – to a degree. An IRA, a 401(k) or a 403(b) helps slice into your income tax bill today, putting more in your pocket now and less in the government’s. But these are tax-deferred plans, not tax-free.

Eventually, the tax bill comes due. When you retire, any withdrawals from those accounts are taxed. And when you turn 70½, the federal government requires you to withdraw a minimum amount, whether you want to or not. People often assume their tax rate is going to be less when they retire, but that’s not necessarily the case.

Those who want to avoid that tax time bomb for themselves – and in some cases for their beneficiaries – could consider other ways to invest their dollars, such as:

  • Municipal bonds. Municipal bonds are used to fund schools, highways or other government projects. Under the federal tax code, the interest income on municipal bonds is tax free. Usually, the interest also is exempt from state taxes.
  • Roth IRA. Unlike a traditional IRA, you don’t get to defer taxes on the income you contribute to a Roth IRA. But the upside is that when you reach retirement age, you can generally make withdrawals income tax free. And if you die with money still in the account, your beneficiaries also won’t pay taxes when they make withdrawals (but could still be subject to estate taxes).
  • Life insurance. Life insurance death benefits pass to beneficiaries income tax free, and it provides other advantages as well. You can use permanent life insurance while you’re still breathing. For example, you can withdraw money from it and you can borrow from it. [The cash value in a life insurance policy is accessed through withdrawals and policy loans, which accrue interest at the current rate. Loans and withdrawals will decrease the cash surrender value and death benefit.] People tend to see the life insurance premium they pay as another bill, not unlike the cable TV or electric bills. Instead, it could be seen as a contribution, much like the contribution to an IRA or a 401(k), because in addition to the death benefit protection, permanent life insurance has living benefits too.

Final Thoughts

It’s always hard to do someone’s planning based on what the future holds. But with our national debt what it is, it’s likely tax rates are going to be higher years from now. So with retirement planning, it often becomes a matter of whether you want to pay your taxes now or pay them later.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

2 Comments

  1. One thing some folks don’t realize is that it’s better to inherit a home than to be gifted one while the person owning it is still alive. If you inherit it after someone’s death, you get a step up in basis on the value of the home. If you were to sell it later you pay capital gains tax only on the growth in the home’s value from the point at which you inherited it. If it were gifted to you while the person is living, you would owe capital gains tax based on the growth in value from the time he originally purchased it.

    • Great input, my friend. That is the kind of analysis that is incredibly helpful when considering potential tax implications.

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