There are things in life that are not a matter of opinion. They are a matter of math.
We do not believe that financial decisions, whether they are about Roth IRA conversions, a snowbird lifestyle, or a gifting program for your children and grandchildren, should be based on an inclination or an unexamined “gut feeling.” Financial decisions should be based on a combination of goals and math. That isn’t to say ignore your gut, either do the math yourself or get professional help and then decide.
If no one “runs the numbers” and you make critical financial decisions based on your gut, you will likely fail to optimize your and your family’s wealth and security.
We believe in using peer-reviewed mathematical calculations and adhering to proven academic data-driven planning to enhance your finances. Yes, the results will depend on the assumptions used to make the projections. But you can begin by using assumptions that you think are reasonable, then you can or someone you hire can “run the numbers” using alternate assumptions to test multiple options. The goal of running the numbers is to arrive at the best solution given your personal goals, values, and your individual financial situation.
Roth Accounts
I have a reputation for being a strong advocate for Roth IRA conversions for people of all ages. But that generalization doesn’t reflect what I really believe. I like to find the best mathematical solution consistent with a client’s values. It just so happens for most clients, at some point in their lives, the client and their family can benefit considerably from a series of Roth IRA conversions. Running the numbers and doing the math can also help you determine the appropriate timing and the amount of a Roth conversion.
I will be the first to admit that Roth IRA conversions are not beneficial for every person or every situation. But follow the math. If you run the numbers projecting the growth for not only your life expectancy, but also for the life expectancy of your children, you will likely get a better result than your gut might have led you to believe.
The Desire to be a Snowbird
Roth conversions are only one example where doing the math can make a major difference. What if you want to rent or buy a second home. Can you afford it? Do the math. Just recently a client who never considered spending several months in Florida every year because he didn’t think he could afford it found out he could easily afford it after doing the math.
Using Disclaimers in Beneficiary Designations is Also About Numbers
I also think that doing the math is very important when it comes to estate planning. Disclaimers allow named beneficiaries to “disclaim” a bequest and then that bequest goes to the “next in line.” A common disclaimer option would be to allow the surviving grandparent to disclaim to their children or at least make a partial disclaimer instead of accepting the bequest themselves. Their children, in turn, could then further disclaim into a trust for their children if that made sense financially.
Disclaimers have been a staple of our estate planning recommendations for many years. But the rubber meets the road after a death. The survivor has nine months to think about and assess their financial situation before they decide whether to either keep, disclaim, or partially disclaim a bequest.
Disclaimers can be advantageous if the first named beneficiary doesn’t really need or want all the money left to them. The consequences, if they have never considered a disclaimer strategy, could easily lead to higher taxes. Furthermore, through the use of disclaimers, the secondary beneficiaries (usually your children equally), will likely benefit from the funds (after the first death) while they are younger and perhaps need it more to improve their immediate living circumstances. The impact of a bequest earlier in their lives might be much greater than if they had to wait until the second death to receive any inheritance.
But the entire point of the disclaimer discussion is, we think, using math to inform your decisions. It plays a critical role in deciding whether to or how much or which assets to disclaim. That doesn’t mean you should never follow your gut―just let your gut be led by an informed decision.
Minimizing Taxes by Considering the Tax Consequences to the Beneficiary
We also advocate for a strategy we call “who gets what.” Once again math plays a key role. When thinking about a will or bequests to family and charities, most people will seek an outcome that all beneficiaries will accept as fair and in character with the decedent’s character. But what is often forgotten in the quest for fairness and generosity is consideration of the tax implications of those bequests. This argument parallels the logic behind the disclaimer technique mentioned above.
We love employing the calculation strategy of “who gets what.” Yes, it takes a bit more thought and evaluation, and perhaps even requires the help of a financial professional to be thorough, but the benefits to your heirs can be significant.
Some Common Examples of Varying Tax Consequences
In most cases, Traditional IRAs, subject to exception, are going to be fully taxable to your heirs. The SECURE Act, that subject to exception, effectively killed the stretch IRA, stipulates that income taxes will be due on your IRA within ten years after your death. But the SECURE Act’s restrictions don’t apply if you leave your IRA to your spouse. After-tax dollars and life insurance proceeds are generally not subject to income taxes. Tax exempt charities don’t pay taxes on any bequest. All these different types of inheritances have different tax implications for your beneficiaries.
Who Gets What: Spouse vs. Children
Doing the math might lead you to leave certain assets to certain beneficiaries and/or the survivor might choose to disclaim certain assets. For example, assume you have a large IRA and a large after-tax brokerage account. Assume your spouse doesn’t need all your money. You can plan either outright or by disclaimer to leave the IRA to your spouse (where she can get a bigger stretch than your kids) and the after-tax dollars (or at least some of them) to your children.
Who Gets What: Charity vs. Children
On this topic, first, let me focus on the smartest solution for donations or inheritances that are left to charity after you and your spouse pass. The drafting mistake of leaving after-tax money to charity is one of the most common errors we see in wills we have not drafted.
In most cases, Traditional IRAs are going to be fully taxable to your heirs. A 501(c)(3) charity that is recognized by the IRS as being tax-exempt does not care in what form they receive an inheritance. They never have to pay taxes on the money they receive. To them, a dollar is a dollar. So, a charity will look at bequests of Traditional IRAs, Roth IRAs, after-tax dollars, or life insurance in the same light. In sharp contrast, your heirs will face substantially different tax implications depending on the type of asset they receive and their financial circumstances.
So, if you were planning to leave $100,000 of your after-tax dollars to a charity but change the plan and instead leave $100,000 of your Traditional IRA money to that charity, you are in effect leaving your beneficiaries an extra $24,000 all at Uncle Sam’s expense! (That assumes your beneficiaries are in the 24% tax bracket.)
This is a simple tweak to your estate plan that can be very beneficial to your heirs. On a smaller bequest, smaller savings. On a bigger bequest, even larger savings. Again, this isn’t rocket science, just math. But the vast majority of estate planners miss it.
Who Gets What: Children in Different Tax Brackets
Many IRA owners have children who can reasonably be predicted to be in significantly different tax brackets. The different income tax brackets of your beneficiaries may create an opportunity for tax savings by simply changing who gets what. For example, imagine you have two adult children, and one child is in the 12% tax bracket and the other in the 32% bracket.
Consider increasing the purchasing power of both of your children after you die and reducing the share going to Uncle Sam by switching who gets what.
Let’s keep it simple and assume you have a $1,000,000 Roth IRA and a $1,400,000 Traditional IRA. The status quo is each of your children will receive 50% of both assets. If you forget growth, each child will get a $500,000 Inherited Roth and a $700,000 Inherited Traditional IRA. The IRS will get $308,000 which represents the taxes both kids will have to pay on the Inherited Traditional IRA. ($700,000 times 12%= $84,000 and $700,000 times 32% = $224,000.)
Let’s assume instead you leave the $1,000,000 Roth IRA to the child in the 32% bracket and the $1,400,000 in your Traditional IRA to the child in the 12% bracket. The IRS would get only $168,000 in taxes. This means your children would get an extra $140,000 worth of purchasing power, which is the difference between the amount paid to the IRS in the two scenarios. Of course, if you include future growth, both from the time you draft your documents to death and the years following, the benefits are even greater.
Did I oversimplify this example and not take into consideration many things that would cause this estimated tax savings to change? Yes. But I wanted to make the point clearly. By doing the math and shifting who gets what, there might be significant tax savings that could benefit both your children.
There will be times when your gut overrules the math. For example, if you don’t have after-tax dollars to pay for a Roth IRA conversion, in many cases the mathematically optimized plan might be to take out a home equity loan and use those proceeds to pay for the conversion. But that option may not sit well with you. That is okay. But, that said, I have had many clients face that situation and though their gut told them not to do the conversion, after seeing the math, they decided to tap into a home equity loan to pay the taxes and make the conversion.
I am not saying you should never do what your gut is telling you. But, if you, or with the help of an appropriate financial professional, run the numbers and do the math at least you will have a lot more information to work with, and chances are you will make better decisions.
Disclaimer: Lange Accounting Group, LLC offers guidance on retirement plan distribution strategies, tax reduction, Roth IRA conversions, saving and spending strategies, optimized Social Security strategies, and gifting plans. Although we bring our knowledge and expertise in estate planning to our recommendations, all recommendations are offered in our capacity as CPAs. We will, however, potentially make recommendations that clients could have a licensed estate attorney implement.
Asset location, asset allocation, and low-cost enhanced index funds are provided by the investment firms with whom Lange Financial Group, LLC is affiliated. This would be offered in our role as an investment advisor representative and not as an attorney.
Lange Financial Group, LLC, is a registered investment advisory firm registered with the Commonwealth of Pennsylvania Department of Banking, Harrisburg, PA. In addition, the firm is registered as a registered investment advisory firm in the states of AZ, FL, NY, OH, and VA. Lange Financial Group, LLC may not provide investment advisory services to any residents of states in which the firm does not maintain an investment advisory registration. Past performance is no guarantee of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee that any strategy will be successful. Indexes are not available for direct investment. If you qualify for a free consultation with Jim and attend a meeting, there are two services he and his firms have the potential to offer you. Lange Accounting Group, LLC could offer a one-time fee-for-service Financial Masterplan. Under the auspices of Lange Financial Group, LLC, you could potentially enter into an assets-under-management arrangement with one of Lange’s joint venture partners.
Please note that if you engage Lange Accounting Group, LLC and/or Lange Financial Group, LLC for either our Financial Masterplan service or our assets-under-management arrangement, there is no attorney/client relationship in this advisory context.
Although Jim will bring his knowledge and expertise in estate planning, it will be conducted in his capacity as a financial planning professional and not as an attorney. This is not a solicitation for legal services.