4 Ways to Hand Down Wealth to Your Heirs

Ensuring future generations benefit from you work and investments isn't as easy as just crafting a will.
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BOSTON (TheStreet) -- While many middle-class Americans are worried about their savings lasting through retirement, the affluent often have a much different concern: how to hand down their excess to heirs.

Ensuring that future generations benefit from hard work and shrewd investments isn't as easy as crafting a will.

Chris Hobart, CEO and founder of

Hobart Financial Group

in North Carolina, explains that there are four IRA strategies that can be used, with various pros and cons, to ensure a smooth legacy.


Hobart laments that "an IRA is a relatively tax-inefficient transfer of wealth."

The common approach many take, a lump sum distribution, is particularly problematic from a tax standpoint.

"When the beneficiary takes a lump sum, that money is fully taxable to them because it is considered ordinary income," he says. "We can see state and federal taxes of up to about 46% depending on the size of the retirement account. So this is obviously a big mistake."

An added pitfall is that if someone doesn't have their beneficiary account set up properly and IRA assets pass through a trust, estate or will, it will all but guarantee that the benefit will be treated as a lump sum distribution with a high tax rate.


A more advantageous approach, geared for those seeking a multigenerational benefit, is typically referred to as either "stretch" IRA planning or legacy IRAs.

This strategy requires a carefully drafted beneficiary statement that clearly states beneficiaries. A spouse is named first, children are secondary and grandchildren third.

"What the children inherit is the remainder of their parents' tax-deferred account, but every year, after mom and dad have passed away, they have to take what is called a 'stretch distribution' or 'minimum distribution' from the account based upon their life expectancy," Hobart says.

Unlike personal or spousal distributions, the children must take immediate annual distributions up to age 85. These start at about 3.6% and grow by 0.5% a year. They are are taxed only on the amount of the distributions, but get to grow the remainder of the account tax-deferred.

True to their "stretch" moniker, this approach adds an even greater tax benefit, because the money is additionally passed on to grandchildren once their parents die.

"The good news is we have just avoided this big tax time bomb," Hobart says. "The bad news is we have also put into our children's lap this fully taxable money, and we don't know where tax rates are going in the future. If everybody is right that tax rates may be going up in the future, even if our kids are only getting minimum distributions we actually might still be giving them money in a tax-hostile environment."


For those most focused on passing money to their kids, a Roth IRA is worth consideration.

The parents convert their IRA assets, paying all taxes upfront (or spreading the transfer or taxes over time) so their money grows and is distributed tax-free to heirs.

"If mom and dad are willing to suck it up and pay those taxes, you can now create a totally tax-free legacy for your kids, which is extremely powerful," Hobart says. "We've totally erased taxes from the inheritance picture and we've done it when the parents are probably in a lower tax bracket than their kids will be."

Mickey Cargile, founder and Managing Partner of Texas-based

WNB Private Client Services

and Cargile Investments, says that while a Roth may make a lot of sense for living and legacy needs, some of his clients aren't convinced of the merits.

"It seems like the wealthier my clients are, the more they distrust it," he says. "They have a fear about the conversion that they are being set up by the government and that they will prepay their taxes and then be re-taxed on it at some point."


A more intricate but tax-beneficial strategy relies on insurance products to help grow and distribute assets.

Hobart refers back to the Roth IRA strategy. If parents convert $1 million to a Roth, they are going to possibly suffer through 25% to 35% in taxes and lose $250,000 to $350,000 from whatever pool of assets they draw the money from.

Given the current economy and market volatility, returns can't be counted on to make up that difference.

Instead, parents pay the tax on the money in a lump sum, or systematically, over five to 10 years. Instead of putting it into a Roth IRA they fund a life insurance policy.

"A lot of folks may not like life insurance, and I'm not a big fan in general, but the one thing I know is that its tax free and it's the absolute best way we can leverage money with a guaranteed death benefit," Hobart says.

For clients who may not get a favorable policy because of health concerns, insurance companies are usually willing to issue a dual policy for spouses that pools risk and pays out only when both are dead. These are often called "second to die" policies.

"We have actually created the best system for tax-free wealth transfer that we can ever imagine from the most tax hostile type of vehicle, an IRA," Hobart says. The fact of the matter is that whenever we have an IRA or 401(k), we are in a partnership with Uncle Sam. Whenever we can take it from an IRA to a Roth or to a life insurance type product, we have taken the government 100% out of the picture."

Cargile offers an important piece of advice to anyone looking to help future generations, no matter what strategy they use.

"The main thing we stress to our clients is to make sure you name your beneficiaries and your contingent beneficiaries exactly the way that you want the money distributed," he says. "We see people take shortcuts and just leave the money to their oldest child anticipating that they will then distribute to the other children. But it just makes the tax consequences that much more complex whenever you do something like that. None of us likes to contemplate death, but it awaits us all. Just sit down and make sure you make the transfer easy on your decedents."

-- Written by Joe Mont in Boston.

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