We will never have the experience of receiving an inheritance, but GCC Jr will.

In my role as fiscal steward, I would like to ensure that he, along with our other beneficiaries, receive the largest amount possible. (After we are done spending as much as we want, naturally.)

But Jr only gets what the IRS doesn’t take, so I’m taking my tax efforts to the next level: multi-generational tax minimization.

Note: The ability to withdraw funds over the beneficiaries lifetime was eliminated in the SECURE Act. Check out the details here.

Multi-Generational Tax Minimization

Much of what I’ve seen with regards to multi-generational tax minimization/wealth preservation is focused on avoiding/minimizing the impact of the Estate Tax, often by companies or persons with a vested interest in selling you a Trust (“Hey little kid, would you like to buy a trust?” said the Big Bad Wolf.)

Trusts have their place, but I have a simple and guaranteed solution to avoiding the Estate Tax altogether and it costs a lot less – just die with less than $22 million in assets. It’s so easy, almost anyone can do it.

With each adult able to pass ~$11 million to their heirs without taxation (at the Federal level), for most of us, the Estate Tax is a non-issue. But it is an incredible opportunity to build a family dynasty. The Kennedys, the Rockefellers, the Curry Crackers…

Even with the Estate Tax out of the way, there is still a lot to consider.

Gifting

There are pros and cons of providing gifts to your adult children. In the book The Millionaire Next Door they call it Economic Outpatient Care, and it is highlighted as a way parents prevent their children from becoming economically successful in their own right. Dependence is a helluva drug.

Our family gifts flow in the opposite direction, but regardless there is a right and wrong way to do it, tax wise.

You may have heard the recommendation to gift appreciated stock to a charity, rather than sell it, pay taxes, and then donate the remaining cash. The charity is able to benefit from the full amount rather than the reduced after-tax value.

There are similar considerations when gifting to individuals.

When a gift is made, the recipient’s basis in the asset is equal to the lower of the original owner’s basis and the current market value.

Unlike a charity, a person has tax obligations, so we need to consider Jr’s tax status – if we gift appreciated shares, when he sells will he have to pay more or less tax than if we sold the stock and gifted cash? Maybe we have a 0% capital gain tax rate whereas he is in his prime working years and would have to pay 15-23.8%.

If we’ve raised our basis over the years and are thus able to sell stock at a loss, are we better off doing so than gifting the stock directly?

Probably. But we should also avoid getting to that point…

Stepped up basis

The basis on inherited assets is stepped up to the market value at the time of death. Unrealized gains on these assets are thus never subject to income tax. It’s the ultimate capital gain harvest, in both senses, and provides a new context for prioritizing Roth conversions vs Capital Gain Harvesting.

Bought some stock or a house for $1 and it is now worth $10 million? No taxes, now or ever.

Got some rare artwork in the basement from a recently discovered star? No taxes.

Antiques, coins, gold, baseball cards…. all no taxes.

It is easy to take advantage of this incredible opportunity – simply do nothing.

And there’s the rub…

I’m a big fan of doing nothing, but this isn’t always possible or the best option.

It can be worth paying some tax now to pay less tax later. This is a good choice if/when we decide to move back to California – I can pay some tax at 15% now to avoid paying some tax at 17-23%+ later.

But with everything being stepped up in basis upon death, harvesting more than we might spend results in paying 15% rather than our heirs paying 0%.

We need to take the Goldilocks approach… not too much, not too little. This seems more of an art than a science.

The exception: Retirement accounts.

Retirement Accounts

The ability to withdraw funds over the beneficiaries lifetime was eliminated in the SECURE Act. Check out the details here.

401ks, IRAs, etc… are tax-deferred vehicles, the key word being “deferred.”

Beneficiaries of an inherited retirement account are required to withdraw those funds, as a lump sum, over 5 years, or with Required Minimum Distributions (RMDs) over the beneficiaries’ lifetime. Upon withdrawal, those funds are subject to taxation, although there is no 10% early withdrawal penalty. (RMDs still apply if the inherited account is a Roth. Roth conversions are an option on inherited IRAs only for a spouse.)

For lifetime tax minimization, the RMD route gives us the greatest number of years to work with, but the 5-year approach could make sense if account values are low and we know those 5 years will be low-income years (e.g. college, sabbatical, etc…)

Standard advice says bequeathing a retirement account to the youngest possible beneficiary is a good way to maximize deferral benefits.

And that is kind of true – the RMD for a 10-year-old is only 1/4 that of the RMD for an 80-year-old IRA originator and only 1/3 for a 40-year-old. However, they ramp up much more aggressively. (The result being the inherited IRA value approaches zero about 15 years earlier than it would have had the original owner lived.) Note the word “minimum” in the acronym RMD.

RMDs & Tax-Deferred Growth

Presumably, a larger RMD will be taxed more heavily, but that isn’t necessarily the case – a large withdrawal by a retired couple with minimal other income may face a lower tax rate than a small withdrawal by a single person during their peak earning years. (Due to single filer brackets being half the size of married couples’.)

This makes multi-generational tax minimization a difficult game. We must not only predict the rate at which withdrawals will be taxed during our own lifetime but also during our children’s or grandchildren’s.

For the original IRA owner, RMDs begin at Age 70.5. With 7% annual growth, even with required withdrawals, the IRA will continue to grow well into our 80s, eventually fading towards zero as we become a centenarian. The RMD accomplished what it was designed to do.

This chart shows the outflows and IRA value based on an arbitrary amount of $1 million at age 70.5 with 7% real annual growth.

Now, if the IRA owner passes at Age 85 (for example) and bequeaths the retirement account to a beneficiary 40 years younger, the IRA can benefit from an additional 60+ years of growth. (A “stretch” IRA.)

RMDs for the beneficiary will start immediately, albeit at a lower percentage, and the IRA will continue to grow well past traditional retirement ages. By the time the beneficiary reaches their own normal RMD age of 70.5, the IRA could have tripled… even after 30 years of minimum withdrawals.

Multi-Generational Tax Minimization, GCC Jr Edition

I’m unlikely to predict our own taxes over the coming decades, let alone Jr’s over the next seven.

But we can give it a shot. Here is a simple enough thought experiment:

I’ll be 45 this year. Jr just turned 4.

If I earmark ~$200k in my IRA as Jr’s inheritance, invested for future real growth of 7%/year, then it will be worth ~$1 million when I hit RMD age in 25 years or so.

My life expectancy is somewhere around 85 years old. I’ll live much longer because I’m a crotchety old bastard, but it’s as good of a target as any for illustrative purposes.

Even with RMDs, the original $200k will grow to about $1.3 million by the time I reach age 85, as shown in the first RMD chart above.

If I pay tax on those RMDs (if any) out of my own pocket, and let the RMD funds continue to grow 7% in a taxable account, then they will grow to an additional $1.3 million.

Jr’s total inheritance: $2.6 million around age 40, $1.3 million in a Traditional IRA and $1.3 million in stocks in a taxable account. (The Economist was right about this one – The simplest way to become rich is to be born to the right parents.)

Based on the 4% Rule, this could sustain a cost-of-living of $104,000/year.

Dividends of 2% would pay $26,000/year.

The RMD the following year would be ~$36k (2.58%.)

Now, what would his tax situation look like, assuming the tax code of the future resembles that of today?

If he were married with no other income, spending 4% (withdrawing additional funds from IRA), taxes would be about $6,500 with a top marginal rate of 12%. (If he instead withdrew basis from the stock in the taxable fund, taxes would be ~$2k, but greater in the future.)

If he were single, taxes would be about $14,000 with a top marginal rate of 22%.

If he were married and earning a median income (single income household), all of the RMD would be taxed at 12% and all of the dividends at 15%, for a total inheritance related tax bill of ~$8,000.

Which of these situations is most likely to apply?

Probably all of them at various points, but as the RMD levels increase rapidly… these tax rates are likely to be the lowest that will ever be paid… by the time Jr is 60 years old, the RMD will be more than $100,000/year.

Hence, if we have the opportunity to pay 10% on Roth conversions anytime between now and our ultimate demise, then we should probably do so…. and maybe even a little at 12%.

Mathematically speaking, choosing to pay 10% now on a Roth conversion is equivalent to paying 10% on a larger withdrawal 60 years from now (associative property of multiplication.) But doing so could guarantee that the future rate isn’t much greater than 10%, a real possibility considering the aggressive RMD rate increase for an inherited IRA (as well as our own potential to pay a very real death tax.)

But can we be more specific? It’s hard to take action when things are a little vague. But such is the future…

Although, I could use the same methodology that I used to analyze Is Your 401k Too Big? to get something a little more precise. (This chart modified to use the more aggressive RMD for Inherited IRAs.)

For a married couple, with no other income, if the IRA value exceeds any of the thresholds in the chart then tax rates will exceed a specific marginal rate. Example: if the IRA exceeds ~$1.4 million for a 40-year-old then taxes will need to be paid at a rate above 12% (see Tax 12% gray line.)

If other income (like a job) fills the standard deduction (Tax 0%) and 10% bracket (Tax 10%) (slightly below median incomes) then thresholds are lower, and we need to reduce our allowed IRA values by roughly $600k (the Tax 10% line) to $800k-$900k to avoid paying tax above a 12% rate.

Or stating it differently, if Jr’s inherited IRA is on track to exceed about $800k-$900k in value (which it will), we should do Roth conversions at rates <12% to get the size back below those levels.

Conclusions

It’s good to be born to parents with a head for $$$, but planning for tax minimization over multiple lifetimes is still a real challenge.

The very generous exemptions to the Estate Tax, combined with gifting, stepped-up basis upon death, and “stretch” IRAs, mean that it is easier than ever to build a dynastic portfolio.

Tax laws may change, and so much of the tax code is situational (married/single, other income/no other income, dividend income or earned income), that no matter what we do we are still only guessing what will result in multi-generational tax minimization. The future is very cloudy.

As such, it is probably best to err on the conservative side (don’t pay tax now if you don’t have to) and take the Goldilocks approach… not too much, not too little.

For the purposes of the Curry Cracker Dynasty, when looking beyond our own lifetime’s battle with the RMD, we will need to be a bit more aggressive… it looks like RMDs will require Jr pay 12% tax rates through much of his adult lifetime.

This tax rate would be a new reference point for tax minimization efforts. If we have the option of doing Roth conversions at a lower rate then we should seize the opportunity.

Note: The ability to withdraw funds over the beneficiaries lifetime was eliminated in the SECURE Act. Check out the details here.