Anticipating an Inheritance? Here’s How to Plan for Tax Efficiency

Not everybody is going to get an inheritance but there are some very important strategies you can implement to minimize your taxes if you are going to receive one.

The ultimate goal of the IRS, no matter how you inherit money, is to get all of the inheritance money into your taxable bucket within the next 10 years, preferably immediately, because that is how they make the most money.

We know that if you inherit money from a taxable bucket you get a stepped-up basis for those investments. Since these investments end up in your taxable bucket, you’re going to pay ordinary income tax on that.

When you inherit money from a tax-deferred bucket it goes into your tax-deferred bucket, however the IRS will force you to realize that money within a ten-year timeframe.

If you inherit a tax-free investment like a Roth IRA you will continue to experience the tax-free growth over the next ten years, but at that point it will all go into your taxable bucket.

The goal of the IRS is to always move your money into the taxable bucket whenever possible. Your job upon inheriting money is to put together a plan that moves the money over into the tax-free bucket as quickly as you can.

When you have money in your taxable bucket, there are a number of different things you can do to get that money into the tax-free bucket. The first step is to make sure you and your spouse are fully funding your Roth IRA’s, as well as your Roth 401(k)’s.

The easiest way to get money into your Roth 401(k) is to increase the amount of money coming out of your paycheck to fund your account, and then compensate for that reduced pay amount with the money from the inheritance.

Remember there is an ideal amount of money to keep in your taxable bucket and a great way to spend that money is by paying the tax on Roth conversions.

The final way to move an inheritance into the tax-free bucket is the LIRP. There are a number of advantages that come with the LIRP and the only thing really limiting you is the size of your death benefit.

The ideal way to have money flow to you is through the tax-free bucket. If it comes to you in your taxable bucket at the peak of your earning years when taxes are higher than they are today you could end up losing up to 50% of those inherited IRA’s.

If it’s not too awkward, you should be having this discussion with your parents to figure out a plan that allows them to convert their dollars to tax-free.

Keep in mind that when one parent dies, the surviving parent’s tax bracket doubles and they will be forced to receive their Required Minimum Distributions and pay taxes at double the tax rate. It makes a lot of sense for everyone involved to preemptively shift those dollars to the tax-free bucket.

If you’re building your Power of Zero retirement strategy right now and know you are going to be inheriting a large sum of money in the next 10 years, there are a number of things you can do with an LIRP to make it big enough to accommodate those dollars. Get your buckets in place to accommodate any future dollars you may be inheriting.