How can I keep from burdening my heirs with an inherited IRA?

[00:00:00] Ralph Estep, Jr.: Have you ever wondered how you can protect your loved ones from a hefty tax bill when they inherit your IRA? Imagine this: you receive a call that you've inherited a massive IRA, only to discover that it comes with an equally massive tax burden. Well, that's exactly what happened to one of my clients.

[00:00:18] Ralph Estep, Jr.: And today I'm going to share that story with you, and I'm going to show you how to avoid putting your own loved ones in the same position. So stay tuned to find out how you can keep from burdening your heirs and ensure your legacy lives on as you intended. That's what we're going to talk about on today's show.

[00:00:38] Ralph Estep, Jr.: Well, let's start by looking back at yesterday's show. Yes, this is Death Week on the Ask Ralph podcast, as somebody said, but yesterday we talked about what happens to your debts after you die. And if you missed it, I want to strongly encourage you to go back and listen. It is crucial information. It can save your family from a lot of headaches down the road. Remember, you can find all of our episodes at askralph.com.

[00:01:04] Ralph Estep, Jr.: Well, let's kick things off with a message from one of our listeners. Kathy writes this:

[00:01:08] Ralph Estep, Jr.: Dear Ralph, I recently lost my father. As I'm going through his estate, I discovered he left me as the sole beneficiary of his IRA. To be honest, at first I was touched by his generosity, but now I'm overwhelmed by the tax implications. I'm worried about how this will affect my own financial situation. Is there anything I can do to minimize the tax burden, and how can I make sure I don't put my own children in the same position when it's my turn to pass on my assets? I know you always have some valuable answers, so I hope you can help me today.

[00:01:41] Ralph Estep, Jr.: Well, Kathy, thank you so much for your message. And first of all, let me start by saying this: I am sorry for you losing your father. Death is a difficult thing to talk about, but I completely understand your concerns, and your situation is really common. I hear about this all the time. And that's exactly what we're going to address on today's show.

[00:02:02] Welcome to the show. My goal today is to help you gain financial freedom while growing in your faith. I want to thank you for joining me on this journey. Today is Tax Talk Thursday. And before we dive into the topic, I want to tell you to go visit our website at askralph.com. There, I want you to join our community. And if you're finding value, I want you to share this show with somebody else who might benefit from the information. And when you join our email list, you join our community. I'm going to give you a free copy of my book. It's called Mastering Your Finances. Now, if you were to go buy this on Amazon, it would cost you 10 bucks, but it's absolutely free when you join our email list.

[00:02:38] Ralph Estep, Jr.: And while we're here, I want to remind you: Don't forget, this show is all about answering your questions. That's why we call it Ask Ralph. So send them to me. Here's my email address: ralph@askralph.com, or you can simply visit askralph.com, click on the microphone icon at the bottom of the screen, and record your message. And I will put your question on the show.

[00:03:03] Ralph Estep, Jr.: As we explore today's topic, let's keep in mind the words of 1 Timothy 5:8: "Anyone who does not provide for their relatives and especially for their own household has denied the faith and is worse than an unbeliever." Ouch. Well, the truth is that verse reminds us of the importance of not only providing for loved ones during our lifetime but also planning wisely for their future after we're gone. And guess what? We're all going to be in that position someday. We're all going to die. That is a certainty. But the other thing this verse does is it emphasizes our responsibility to care for family members, and that directly aligns with the episode today. We're going to focus on estate planning. We're going to talk about protecting heirs from unnecessary financial burdens. And it underscores this main purpose: that with proper financial planning, it's not just a practical matter but also a spiritual one. And that's why this show is all about your Christian perspective on finance.

[00:04:06] Ralph Estep, Jr.: Well, let me start today's show by sharing a story that really brings home the importance of today's topic. A few years ago, I had a client—let's call him Victor. Victor came to me distressed. I mean, you could see it in his face. Now Victor had just inherited a substantial IRA from his uncle, which was fantastic.

[00:04:24] Ralph Estep, Jr.: His uncle was generous and wanted to provide Victor with money after he was gone. Now, on the surface, this was fantastic. This was a wonderful gift that was found money. But as Victor and I dug into the details, the reality of the situation started to sink in. Now Victor's uncle was very successful.

[00:04:41] Ralph Estep, Jr.: He had accumulated over $2 million in his IRA over his lifetime. That was put in there with hard work—day in and day out savings. And listen, that's an impressive sum. And Victor was thrilled. Like I said, it's found money. But here's the complication. Because Victor wasn't his spouse; he was his son. Victor couldn't simply roll that inherited IRA into his own account.

[00:05:04] Ralph Estep, Jr.: Instead, he was required to start taking distributions immediately. And if you understand how that works, here's the problem: Those distributions were taxable as ordinary income to Victor. Now Victor was a hardworking person himself. He was already in a high tax bracket due to his own successful career.

[00:05:24] Ralph Estep, Jr.: And these additional distributions, what did they do? They pushed him into an even higher tax bracket. And what did it do? Well, it effectively erased a significant portion of this inheritance because of those taxes. And here's the bigger issue: Because of the size of the IRA, Victor was forced to take substantial distributions every year.

[00:05:45] Ralph Estep, Jr.: He didn't need the money. Victor was doing well himself, but he had to take it. That's just the truth. So I'll never forget: Victor came in, we sat down face to face, and we started putting together a tax plan of what this was going to look like. And I calculated it. I said to Victor, "Listen, Victor, you are going to end up paying $800,000 in taxes over the next 10 years just from this inheritance." He was shocked.

[00:06:11] Ralph Estep, Jr.: He couldn't believe what I was telling him. So what was intended as a generous gift had turned into a significant financial burden. Now listen, a lot of people are probably saying, "Ralph, dude, think about this. Victor just got $2 million that he wasn't expecting." And that's true. I can't argue with that. But on today's show, I want to talk about what are some ways that we can mitigate that tax cost. Because I think about it: Victor inherited $2 million in the IRA, but it cost him $800,000 in taxes. So as much as his uncle wanted to provide for him, he only was able to give him $1.2 million of that $2 million because of the tax burden.

[00:06:50] Ralph Estep, Jr.: So good old Uncle Sam got almost 50% of that money. And the problem is Victor's story isn't unique. In fact, you know what? Right now, this has hit close to home for me. My mother-in-law is going through dementia. She's in a great facility, but her finances are structured in a very similar way.

[00:07:09] Ralph Estep, Jr.: Most of her money is in that IRA. Now she intends to leave it to her children. And that's wonderful. Those are great intentions. But the problem is, I've talked to my wife, and I've talked about it with her sister. You know, they have to deal with the tax implications when the time comes.

[00:07:26] Ralph Estep, Jr.: So you might be asking, "Ralph, what can we do to prevent this situation? How can we keep from burdening our heirs with an inherited IRA?" And I don't have all the answers, but I have some things you can try. So let me share some strategies that can help you. The first thing you might want to consider is what's called a Roth conversion.

[00:07:43] Ralph Estep, Jr.: So that's an effective strategy where you gradually convert that traditional IRA money to a Roth IRA. And yes, you're going to pay taxes on that converted amount, but the heirs are going to thank you later because those IRAs grow tax-free. And when they go to distribute that money, there's no tax at all.

[00:08:00] Ralph Estep, Jr.: I talked about this on a prior show. There are a bunch of things you’ve got to consider when you’re looking at doing this, but it's something you might want to look at to mitigate that tax cost. Another thing you could do is consider using life insurance. You could use some of your IRA distributions to fund a life insurance policy.

[00:08:16] Ralph Estep, Jr.: Why would you do that, you ask? Well, the death benefit from life insurance is generally tax-free to your beneficiary. So that would give them a lump sum that isn’t subject to income tax or required distributions. Another option you could consider, if you’re charitably inclined, is setting up a charitable remainder trust.

[00:08:35] Ralph Estep, Jr.: If you name that charitable remainder trust as your IRA beneficiary, this can provide income for your heirs for a set period of time, with the remainder going to the charity. And that's really a win-win that can reduce the tax burden on your beneficiaries. Again, that's a very specific thing.

[00:08:51] Ralph Estep, Jr.: You want to talk to somebody like myself specifically about how to do it. Nothing you can do. And this one is sort of a no-brainer. A lot of financial advisors miss this. One of the things you can do is spend down your IRA. This might sound counterintuitive. Amazing. And Ralph, wait a minute, dude.

[00:09:07] Ralph Estep, Jr.: That makes no sense. But if you've got other assets, you might want to consider spending your IRA funds during your lifetime. That way, when you get to the end, you don't have a big chunk of IRA. So, you use your IRA for living expenses and leave more tax-efficient assets to your heirs. Another thing you can do is split this over multiple beneficiaries.

[00:09:29] Ralph Estep, Jr.: Instead of leaving your entire IRA to one person—and what's funny about this is I've seen this play out where a person might pass away and they left it to one person with the intention of that one person splitting it among the other beneficiaries—that is a bad plan. One of the things you should consider doing is splitting it right up as a named beneficiary, because what this effectively does is spread out that tax burden and keeps each beneficiary in a lower tax bracket.

[00:09:56] Ralph Estep, Jr.: Again, it depends on the specific situations of your situation, so you want to talk with a tax professional and talk to your attorney before you get into it. And the final thing—this one is huge—you've got to educate your heirs. You've got to make sure every beneficiary understands the implications of inheriting an IRA. To be very candid with you, in our family,

[00:10:19] Ralph Estep, Jr.: Most people had no clue until I laid it out for them. They were like, "Ralph, wait a minute. You're telling me that the money we're going to inherit from mom, when she passes away, we're going to lose 40% of that in tax?" And I said, "Yeah, if you don't structure it correctly, that can happen." So I'm going to encourage you to educate them and encourage them to seek professional advice before making any decisions about those distributions.

[00:10:40] Ralph Estep, Jr.: Because once you're gone, they're going to get a call or a letter from the person who handles that IRA, and they're going to have a couple of boxes to check. And remember this: the key with all of this is to start planning early, because these strategies take time to implement, especially those conversions and especially, you know, spending down that money.

[00:10:57] Ralph Estep, Jr.: But the sooner you start, the more options you're going to have. Now, I want to go back to Kathy's question about what she can do in her current situation. Now, Kathy, as I've alluded to, your options are more limited now that you've inherited an IRA. You know, you can't go back and have your father spend that money down, or split that with other beneficiaries, or put it in that remainder trust, but there are some steps that you can take.

[00:11:18] Ralph Estep, Jr.: So what are those steps? The number one thing you want to do—this is a no-brainer—you want to stretch out those distributions. The IRS allows you to take those inherited IRA monies over 10 years. Now, again, this is going to depend on your personal tax situation. If you're retired yourself and you don't have a lot of income,

[00:11:37] Ralph Estep, Jr.: We can take a look to see what impact this would have based on the different tax brackets. So you've got some flexibility by using that 10 years. You definitely probably are not going to take it all in one year, but let's say you take it over 10 years; then you can smooth that out over that 10-year period.

[00:11:54] Ralph Estep, Jr.: Let me give you a simple example. Let's say that somebody leaves you $500,000 in the IRA. Now, if you take all of that money in the current year, that's going to add $500,000 worth of ordinary income to your tax return, and that's going to zonk you on the tax rate. It's just going to do that. So one of the strategies you can employ, like I said, is to take that over 10 years.

[00:12:14] Ralph Estep, Jr.: So instead of adding $500,000 in one year, you're going to add $50,000 to each year. That's going to certainly not put you in that highest tax bracket. Again, it depends on your situation. Another thing to consider is using inheritance strategically, and this one is just, it's more of a function of how you're handling your money.

[00:12:34] Ralph Estep, Jr.: So use those inherited funds for specific purposes that align with your financial goals. Maybe it's a good time to pay off high-interest debt. Maybe this is a good time to put a lot of money away for your children's education. If you use it strategically, you might not get that tax benefit right away,

[00:12:51] Ralph Estep, Jr.: But over the long term, it's going to serve a good purpose. And this one, again, I want to stress this 10 times and three times on Tuesday, and that is consult a tax professional. This is not a simple situation. This is complex. This is not something you're going to solve with TurboTax or by finding your answer online.

[00:13:09] Ralph Estep, Jr.: It is crucial that you work with a qualified tax advisor who can help you navigate the rules and optimize your strategy. That's what we do. And for ensuring you don't put your own children in a difficult position, Cathy, like you asked me, the strategies I mentioned earlier—like looking at Roth conversions and using life insurance—

[00:13:27] Ralph Estep, Jr.: Those can be excellent tools to consider as part of your estate planning. But again, we need to look at your particular situation. So let's do a bit of a recap. Today, we explored the potential pitfalls of leaving a large IRA to your heirs. It's a cool thing to do; it's a beautiful thing to do. But there are ways to help mitigate that tax burden.

[00:13:45] Ralph Estep, Jr.: We talked about how to mitigate those taxes because the overall goal is to pass on your hard-earned wealth in the most efficient way possible and minimize the tax burden on your loved ones. Like Kathy said, in that situation I had where the person inherited $2 million in the IRA, but the IRS was going to take $800,000 of that. Now, I know right now you might be feeling overwhelmed.

[00:14:12] Ralph Estep, Jr.: You might be thinking all this information is just too much and your head's going to explode. Well, don't worry about it. I'm here to help you. I want to encourage you to schedule an appointment with me, and we can create a personalized plan for managing your finances. Maybe you need help managing that estate stuff.

[00:14:25] Ralph Estep, Jr.: You can sign up for a consultation with me. I charge $150 for that consultation fee. You can do that at askralphpodcast.com/store. I will work with you to improve your personal finances. Maybe you have a business and need some help with managing those business finances or growing your business.

[00:14:46] Ralph Estep, Jr.: I can help you achieve all of your personal financial goals. All you've got to do is start by scheduling today, and let's create a plan that ensures your legacy benefits, and you set your loved ones up exactly how you intend. Now, tomorrow's show, we're going to talk about why a great credit score matters, even in retirement. A lot of people don't think about this, and we're getting off death,

[00:15:08] Ralph Estep, Jr.: so that's even better. It's a topic that might surprise you, and I promise it'll be an eye-opening discussion. Remember this: my passion is to help you achieve financial success. I want you to live out your dreams, grow in faith, and I know that together, if we work together, we can master your finances from a Christian perspective.

[00:15:26] Ralph Estep, Jr.: So, as I always say, stay financially savvy, and God bless you.