Tax-Efficient Retirement Distributions with Inheritance in Mind

The following is excerpted from Chapter 11 in Wade Pfau’s new book, Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success. It is available at Amazon, Barnes & Noble, Target, and other leading retailers.

[Author’s note: William Reichenstein recently wrote a piece for Advisor Perspectives that objects to my use of the term “tax-bracket management” when I am including non-linearities in the tax code that cause marginal tax rates to different from the federal tax brackets for ordinary income. If this is confusing, replace “adjusted gross income management” with “tax-bracket management” in your mind as you read the following. The ideas that Reichenstein described in his column are already fully embedded into this analysis.]

We now shift to a discussion of taxes and legacy when estate tax is not a concern because asset levels are below the estate tax exemptions. We described tax-efficient retirement distributions in Chapter 10 as the process of using tax-bracket management and strategic Roth conversions. Tax-efficient distributions generally involve spending from a blend of taxable and tax-deferred assets first, and then from a blend of tax-deferred and tax-free assets once the taxable accounts have been depleted. When considering how to position financial assets also for inheritance, we include:

  • The step-up in basis available for taxable assets at death means that bequeathing appreciated securities can avoid capital gains taxes compared to if those assets are sold during one’s lifetime.
  • Tax-bracket management should also incorporate the marginal tax rates that heirs will pay on any inherited assets.
  • When multiple heirs face different tax rates, the inheritance can be designed to improve efficiency by having unequal pre-tax inheritance amounts that are equalized after tax payments to provide more after-tax value for all recipients.

Addressing these matters in order, an important aspect of the tax code is that capital assets receive a step-up in basis at death. This means that the cost-basis for determining taxes is reset to the fair market value of the asset at the time the owner dies. This is relevant both for taxable assets held in brokerage accounts as well as for real estate and other related assets that track a cost basis for tax purposes. As for exceptions, annuities and retirement plan assets do not receive a step-up in basis. For assets experiencing large appreciations, the step-up in basis can imply a huge reduction in potential capital gains taxes. Sell the asset while alive and capital gains taxes are due; leave it for an inheritance and those capital gains taxes disappear. Joint ownership of assets such as real estate can eliminate the possibility of receiving a step-up in basis at death, though for community property a complete step-up may be possible at the death of either owner. Losing the potential for a step-up in basis can create a costly tax mistake for appreciated assets.