• Hugh F. Wynn

How to Maximize Your Inheritance Allocations

After spending a busy and fruitful life investing in high-quality, diversified products properly located in a well-organized portfolio, you get to pick who you want to bequeath them to after you leave this earth! It can be fun and rewarding to plan for the proper disposition of any surplus to family, friends and favorite charities. Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.


Allocation & Location

In personal finance, we talk a lot about asset allocation – what percentages of our investment dollars we allocate to stocks, bonds, and to international assets, etc.


Equally important, but often less mentioned in conversation, is the proper location of those assets in a portfolio’s storage bins. And why? Because asset location is critical to the optimization of tax savings. It's important to make sure that your least tax-efficient assets wind up in post-tax retirement accounts (e.g., a Roth IRA) rather than in taxable accounts. Tax-inefficient assets can generate considerable tax costs if wrongly placed in taxable accounts. For example, if an individual invests in an actively managed stock fund with high annual turnover, it’s best not to place the fund in a taxable account.


Pre-Mortem Decisions

It’s very important you give consideration to what assets go to which beneficiaries - and from which asset locations - prior to arriving at death’s dark door. In other words, carefully decide your inheritance allocation as soon as possible, if you have not already.


Too many folks simply decide to take a pro-rata approach…it's not necessarily wise, but they do it. So let’s look at the alternatives.


Here's an example based on how "Grandpa" stores his assets and how he plans to bestow them. He plans to allocate his assets as follows:

  • 50% to his children

  • 20% to his grandkids

  • 30% to charity

Now, let’s assume that during his working life, Grandpa acquired assets that ended up in:

  • 40% in tax-deferred accounts

  • 25% in taxable accounts

  • 15% in a Roth IRA

  • 20% in Grandpa’s home

How should Grandpa divide assets in those various location accounts to accomplish one of his important goals - an optimal tax-efficient allocation?


Tax-Deferred/Taxable Assets

Let’s first consider the tax-deferred account assets. They are an ideal origin for gifts to charity. Why? A charity isn’t taxed on the value of gifts received. Not so with beneficiaries (people) who will likely have to pay tax as such assets upon distribution from tax-deferred accounts.


It goes without saying that during Grandpa’s retirement years, he will most likely spend his taxable or tax-deferred account dollars when his own marginal tax rate is lowest in order to best preserve capital for the long-term.


Some taxable assets work equally well for both tax-exempt charities and for folks who, under current tax law, inherit taxable assets on a step-up in cost basis. In the “step-up” case, these beneficiaries can sell the assets immediately upon their benefactor’s untimely demise – should they wish to – incurring little if any short- or long-term capital gain tax obligation.


Roth Assets

What about Grandpa’s Roth account assets? Well, tax-wise, it makes no sense to gift them to a tax-exempt charity. Because gifts arrive tax-free, charities have no reason to prefer after-tax Roth dollars over tax-deferred dollars. But you can bet that, because of their individual marginal tax rates, Grandpa’s children or his grandkids would very much prefer those after-tax Roth assets.


And here’s another thing to consider with the Roth account assets. Should they go to the grandkids or to grandpa’s children? There was a time not so long ago when Roth IRA proceeds could be withdrawn over a beneficiary’s lifetime without tax consequences. For that reason, it made sense to leave such assets to the youngest among the kids…or grandkids…to optimize tax-free growth for as long as possible. Not anymore. In today’s less-friendly tax environment, Roth benefits often have to be distributed by no later than 10 years after Grandpa’s death regardless of who the recipient is.


So, leave the Roth dollars to the beneficiaries with the highest marginal tax rates – keeping in mind that if the grandkids are beneficiaries and are under 18 - or under 24 and full-time students - the so-called “kiddie tax” could cause those same beneficiaries to have a marginal tax rate that’s the same as their parents’ rate. We’ll not get into the “kiddie tax” particulars in this blog. Just be aware of its potential consequences.


In Sum

In short, the ideal location of an individual’s allocation under current law would likely be to direct Roth assets to the kids and grandkids (optimally, to those kids and grandkids currently paying the highest tax rates) while directing tax-deferred assets to charities…with any residual taxable assets such as Grandpa’s home to the kids.



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