Most retirees are in a lower tax bracket than their working-age children, so if grandma had paid the income taxes on her IRA and converted it into a Roth IRA, then her daughter would have a zero tax burden on the inheritance. This brings up an advanced financial planning idea—perhaps daughters and sons who will someday inherit their parents’ IRAs should pay their parents’ taxes.
The IRS allows us to gift to anyone any amount of money. But, if you don’t want to file an extra tax return, the size of the gift is limited. In 2020 you may gift $15,000 per giver, per recipient, without having to file a gift tax return. Inheritors in tax brackets higher than their parents should consider gifting the income tax burden of their inheritances to their parents. They may inherit their parents’ retirement accounts completely tax-free. And if the burden is less than the annual gifting limit, the tax planning is simple.
Here’s how it works. The inheritors work with their wealth manager and decide how much of a Roth conversion to do this tax year that keeps their parent(s) in a low tax bracket. Their parents sign the forms to complete a Roth conversion. When taxes are due, the inheritors make a gift to the parents equivalent to their parents’ additional taxes owed. This way, the kids inherit a tax-free Roth IRA.
Let’s look at our same example. Mom is making $86,000 per year and in the 24% bracket. If grandma is in a lower bracket, mom can save at least the difference in taxes. If your taxable income is more than $86,000, then your benefits are larger.
|Parent’s taxable income under||Tax bracket||Inheritor’s tax-free Roth IRA inheritance|
The inheritors may no longer keep the Roth IRA more than 10 years, but they have no reason not to keep it growing tax-free for the full 10 years. At the same assumed 7% interest rate, the growth more than overcomes the tax burden.
|Parent’s tax bracket||After 10 years…|
In fact, in all cases, over those 10 years, to overcome the taxes paid by inheritors an account only needs to earn (at most) 2.8% per year.
|Parents’ tax bracket||Cost||B/E rate|
The gift keeps on giving. It’s not just a benefit for inheritors, but for parents who may live a long time. The longer the parents live, the bigger the inheritors “gift,” as shown below.
|Parents’ tax bracket||10 years||20 years||30 years||40 years|
The family grows the money for the life expectancy of the parents plus 10 years. After that, the inheritors have to put the money into a taxable investment account.
This is one good way to turn Congress’s 2019 lump of coal into a gift more like something Santa might bring.