Key Steps Before Passing Assets to Your Children

Deciding whether or not to leave an inheritance for your children can impact the amount of money that you save, the retirement plans that you choose, and how you take qualified retirement plan distributions.

However, beyond a desire that you may have to leave some wealth to your children, there are some essential personal financial issues to deal with first. And not all of them are related to taxes.

Learn more about the many factors to weigh before you leave an inheritance to your children.

Prioritize Your Income Needs

Some retirees give away their retirement savings without considering their own income needs. Before you make gifts to others, it’s important to assess how much you need to spend on yourself. Retirement calculators, such as those available from AARP, can help you to determine how much you need to save and how much you can withdraw each year once you retire.

Be sure to take into account the impact of inflation and taxes and maintain a diversified portfolio of growth and income investments that can help your portfolio keep pace with inflation.

Prepare for Increasing Healthcare Expenses

The biggest risks to your retirement income and your children’s inheritance are unexpected illness and high healthcare costs.

Government programs are often of little assistance when it comes to paying for nursing homes and other forms of long-term medical care. Medicare covers a limited amount of nursing home care, and Medicaid requires that you spend almost all of your own money before it pays for long-term care.

You cannot simply transfer assets to family members to qualify for Medicaid, as the program restricts benefits if asset transfers were made within several years prior to a nursing home stay.

Some people protect their assets from the costs of catastrophic illness with a long-term care insurance policy, which can be purchased either individually, through an insurance agent, or through a group plan with an employer. However, these policies are very expensive and have a number of coverage limitations, so you should consider them carefully.

Investing Strategies for Longevity

What if you outlive your retirement fund? When you are over 90 years old, your children and grandchildren may celebrate every one of your birthdays gratefully. But if you have spent your nest egg, they may also be paying some or all of your bills.

With longer life expectancies, it’s essential to manage investments and retirement plan withdrawals to avoid depleting assets during your lifetime.

As a solution, you could buy an immediate annuity with some of your retirement funds to ensure that you receive a guaranteed amount of money for at least as long as you live. Certain pension and retirement plans may allow you to stretch payments that you receive over single or joint life expectancies rather than receive the proceeds as a lump sum.

Understand the Tax Implications

If you expect to inherit assets from your parents, you may be in a better position financially than someone who does not expect to receive an inheritance.

Keep in mind that certain inherited assets, such as stocks and mutual funds, are eligible for favorable tax treatment called a step-up in basis. If you are leaving assets to others, then this tax treatment could mean significant savings for heirs.

Inherited IRAs

Additionally, be aware that if you inherit an individual retirement account (IRA), you may be subject to specific rules regarding when you must take distributions.

Internal Revenue Service (IRS) regulations require that non-spousal beneficiaries of an IRA inherited from an owner who died in 2020 or later, and had started taking RMDs, take annual required minimum distributions (RMDs) from the IRA. And the IRA must be emptied by the end of the 10th calendar year following the year of the IRA owner’s death.

Why a Trust Might Be Beneficial

It may make sense to set up a trust to control distributions from the estate to the surviving spouse and children in certain situations. If you or your spouse have children from previous relationships and you don’t have a prenuptial agreement, trusts can ensure that specific assets are passed to designated children.

Children who are well off may prefer that you keep every penny of your nest egg rather than hand it over during your lifetime. Discuss the transfer of your estate with them.

Smart Investment Choices for an Inheritance

Those with very large estates may expect children to pass inherited assets to grandchildren. A portfolio designed to last multiple generations should grow, preserve capital, and generate income with investments like growth and income equities and a portfolio of laddered bonds.

Inheritors who wish an estate to last several generations should withdraw income only and avoid dipping into principal. 

Estimate the amount of the inheritance you will leave to your children by considering rising prices or inflation, as well as years of compounded investment growth.

Creating a Lasting Legacy

Once you have considered all your options, there are several methods by which to pass along funds to your loved ones.

Gift Assets

Gifting assets is one way to allow loved ones to make use of your money while you are still alive. Gifts qualifying for the annual exclusion from gift tax—often called “annual exclusion gifts”—are entirely tax free and do not require filing a gift tax return.

A separate annual exclusion applies to each person to whom you make a gift. The annual gift tax exclusion changes annually to compensate for inflation and the costs of living.

While gift recipients will not receive a step-up in cost basis, any capital gains will be taxed at their applicable rate, which may be lower than yours.

Some people gift to children or grandchildren using custodial accounts set up under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA). However, depending on a recipient’s earned income and status as a student, the earnings in the account may be taxed at the donor’s tax rate rather than the child’s rate. Others may opt to open a joint account with the minor child or buy savings bonds in the child’s name.

Bequests made to charities are not subject to any limitations and are deductible from ordinary income.

Create a Trust

Trusts protect your children’s interests, and the assets in them avoid probate (which maintains privacy). You can appoint a company, such as the one that helped you establish the trust, or a knowledgeable and trusted person as the trustee to manage assets and control distributions from the trust.

An irrevocable trust is considered a gift, so you can’t control it or take it back. However, with a revocable living trust, you own and control the assets while you are alive. When you die, they pass to beneficiaries as part of your estate.

Defer Income

Retirement accounts such as deductible IRAs and 401(k) plans defer taxes on capital gains, interest, or dividends from investments until the money is withdrawn. At that point, it is taxed as ordinary income.

If you anticipate being in a higher tax bracket at retirement than you are now, a Roth IRA allows earnings to accumulate tax free, and there are no taxes on withdrawals.

Life Insurance or Tax-Deferred Variable Annuities

With life insurance, your beneficiaries receive the proceeds tax free, without having to go through probate or worrying about stock market fluctuations.

Fixed or variable annuities allow you to participate in the stock market through mutual funds or fixed-income investments and have a life insurance component. However, these policies often carry hidden charges and fees, so it’s important to shop around and study them carefully.

Additionally, the Setting Every Community Up for Retirement Enhancement (SECURE) Act made annuities that are held in a 401(k) plan portable. This means that people who inherit an annuity that’s part of a 401(k) can transfer the annuity into another direct trustee-to-trustee plan. This eliminates the need for the beneficiary to immediately liquidate the annuity, which could trigger surrender charges and fees.

Understanding Estate Planning Legalities

Make sure that you take care of the legal details below to ensure that your estate plan will work the way you want it to. An estate attorney or a financial planner who specializes in estate planning may be helpful in explaining these details further.

Beneficiaries

• Review the beneficiaries on all accounts.
• Changing beneficiaries may require your spouse’s consent.
• List secondary beneficiaries in case your primary beneficiary dies before you.
• Your retirement accounts pass to beneficiaries without going through probate court; however, if you leave a retirement account to your estate, it may have to go through probate before the assets can be distributed.

Probate

• Know the probate laws in your state. 
• Investment accounts without a joint owner or documented beneficiary may have to go through probate, a potentially long and costly process, to change ownership.

Wills

• Draw up a will.
• Dying without a will (called “dying intestate”) means that state law determines how your investments are divided among relatives.
• If you have no living relatives and no will, your assets escheat back to your state of residence.

The Bottom Line

Whether or not to leave your children an inheritance requires thought and planning. The above suggestions may not be right for everyone, so it’s important to consult an attorney or tax advisor to determine what makes the most sense for you.

Evaluating distribution options for your nest egg can help to ensure that your wishes are followed while maximizing flexibility for your heirs.