One of the most common mistakes we see with estate plans isn’t some advanced nuance.
It’s actually much more straightforward – they plan to give their IRAs, which house a huge amount of accumulated tax liability, directly to beneficiaries while giving other assets to charity.
Most of our clients at Values Added are passionate about leaving money to both *people* and also *causes* they care about. Which kinds of accounts you leave to your descendants and which you leave to charity will have a major influence on how much tax is due. If you do this in a savvy way, you can do more good for causes you support and also for people you care about. And if you do it clumsily, you might end up distributing more to the government than you’d intended, which could mean that both your loved ones and the charities you want to support with your estate get less.
Why IRAs Can Be Problematic in Estate Plans
On the surface, IRAs are a straightforward way for you to save for your personal financial goals. They’re tax-advantaged accounts, offer a variety of investment options, and you can send them directly to beneficiaries if you pass away. Unfortunately, it’s not always that simple, since IRAs can have a high tax cost to those who inherit them. Sometimes that tax cost for the inheritor is even greater than the tax benefit the owner received in their lifetime.
However, what not enough people realize is that IRAs can be a tax problem for beneficiaries navigating an inheritance.
The Tax Burden on Beneficiaries
Unlike other assets your heirs might inherit, such as real estate or stocks, IRAs come with some major taxes embedded in them. When beneficiaries withdraw funds from an inherited traditional IRA, they are required to pay income tax on each distribution just as if it were their own wage income. This is fundamentally different from most other inherited assets, which receive a step-up in basis at death, essentially erasing all the capital gains that had accrued in the descendents lifetime and allowing heirs to inherit those assets tax-free and with no embedded taxes either. With an IRA, the tax liability follows the money to the next generation.
The 10-Year Distribution Rule
It used to be that a recipient of an inherited IRA could take a small amount of the IRA each year, which usually allowed them to avoid getting pushed into a higher tax bracket.
That changed in 2019, when new rules required most non-spouse beneficiaries to empty the entire inherited IRA within 10 years. The new rule pushed many inheritors into higher tax brackets (sometimes much higher!).
Even more problematic: these mandatory withdrawals often occur during beneficiaries’ peak earning years, when they’re already in higher tax brackets. The result? More of the inheritance goes to taxes instead of your heirs.
Limited Flexibility for Heirs
Adding to the complications, beneficiaries have remarkably little control over the timing of their distributions. Starting in 2025, if the original account owner had reached their required minimum distribution age before death, beneficiaries must also take annual required minimum distributions during the 10 years.
These forced distributions may occur at the worst possible times, such as when the beneficiary receives a bonus, sells a home, or experiences other significant income events. This lack of flexibility can result in thousands of dollars in unnecessary taxes that could have been avoided through better planning and management.
Estate Planning Alternatives
Fortunately, there are other ways to pass wealth to your heirs while minimizing their tax burden.
Roth Conversions During Your Lifetime
Converting your traditional IRA to a Roth IRA requires paying income tax on the converted amount now, but provides two major benefits for heirs:
- They won’t owe income tax on withdrawals and
- The taxes paid on conversion immediately reduce the size of your taxable estate.
If you’re in a lower tax bracket now than your heirs will be during their peak earning years, this strategy can be hugely beneficial to your family from a tax savings perspective. Plus, you control when and how much tax gets paid, rather than leaving that burden to your beneficiaries to figure out while they’re also juggling the rest of your estate and grieving. Plus they can let the assets in the inherited Roth IRA continue to compound tax-free for ten years after they inherit it without having to take out any required minimum distributions along the way. You should generally avoid this approach if you are in a higher tax bracket than your heirs are likely to be in during the ten years following your death.
Charitable Giving Strategies
If philanthropy is part of your legacy, IRAs are usually ideal assets to leave to charity. That’s because charities don’t pay income tax on IRA distributions, which means 100% of the value goes to your chosen cause.
Meanwhile, you can leave other assets that receive a step-up in basis, like stocks or a family home, to your heirs. This approach maximizes what both your beneficiaries and your favorite charities receive.
Giving & Estate Planning: A Real-World Case Study
Here is an example based on a composite of scenarios we often see in practice.
Suppose our team were working with a client whose parent was charitably inclined and held both IRA and non-retirement investments. The parent had done well financially, and their estate was expected to be subject to both federal and state estate taxes.
In this example, the parent’s IRA was valued at $1 million. Had that IRA been left directly to their four children, here’s what could have happened:
- The IRA would first trigger $400,000 in federal estate taxes (at a 40% marginal rate) and $160,000 in state estate taxes (at a 16% rate), both of which would need to be paid from other assets in the estate.
- As the heirs began taking distributions over the next ten years, they’d likely pay another $200,000 or more in federal and state income taxes, even after using the special deduction available for IRAs that were subject to estate tax.
- Any additional growth in the IRA over that decade would also be taxed as ordinary income to each heir.
Altogether, the family could face around $760,000 in combined federal and state taxes on a $1 million inheritance.
In situations like this, we often present both options to families: Would the next generation prefer to inherit the IRA with significant taxes due, or would they rather have the parent direct the IRA to donor-advised funds instead? In our fictional example, the family chose the second path—creating greater charitable impact and a more tax-efficient legacy. Each of the four heirs could then recommend about $250,000 in charitable grants to organizations of their choice, rather than inheriting an IRA reduced by roughly $190,000 each in taxes.
What to Do If You Inherit an IRA
If you’ve already inherited an IRA and are now worried about the tax conundrum you’re dealing with, it pays to understand your options.
Understand Your Timeline and Rules
First, determine what type of beneficiary you are. Spouses have unique options, including the ability to treat the inherited IRA as their own or roll it into their existing IRA. Non-spouse beneficiaries generally must withdraw the account’s funds within 10 years of inheriting the account. If the original owner had started taking required minimum distributions, the beneficiaries would also be required to take annual distributions during those 10 years.
PS – Need help figuring out what to do if you’ve inherited an IRA? Schwab has a solid calculator to help you get started.
Not a Spouse? Consider Strategic Distributions
Don’t wait until year 10 to take everything out in a lump sum! Spreading withdrawals over the 10 years of account ownership typically reduces taxes for most heirs, especially if they take larger distributions during lower-income years, such as between jobs, during a sabbatical, or in early retirement before Social Security payments begin. Strategic timing can help you stay in lower tax brackets and preserve a larger portion of your inheritance.
Avoid Penalties: Bring In The Pros
Inherited IRA rules are complex, and the stakes are high. A mistake could trigger penalties or unnecessary taxes. Working with a qualified tax professional or financial advisor who can analyze your specific situation, calculate optimal distribution strategies, and coordinate the inherited IRA with your overall financial plan can set you up for long-term success. Plus, you can talk to them about how to leverage your inherited assets better to accomplish your personal goals, such as:
- Increased charitable giving
- Becoming work optional or pivoting your career
- Supporting your own kids and grandkids
When it comes to IRAs and estate planning, proactive planning today beats reactive management tomorrow. Whether you’re setting up your estate plan or managing an inheritance, the right strategies can save thousands in taxes and provide greater financial security for your family.