Why a Traditional IRA or 401(k) is the Worst Asset to Leave Your Loved Ones

If you’ve worked hard, saved wisely, and had a bit of luck, you may find yourself with a nest egg to pass on to your loved ones. But did you know that a traditional IRA or 401(k) could be the worst asset to leave behind? For many people, these accounts are the largest assets they’ve built up—but changes in tax laws mean they’re now far less beneficial to heirs. Let’s explore why this is and what you can do about it.

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What Changed?

In the past, a non-spouse beneficiary of a traditional IRA could take required distributions over their lifetime. For example, if someone inherited an IRA at 45, they might have 40+ years to withdraw the funds. This allowed the account to grow while spreading out the tax burden over decades.

In 2019, however, a new rule was introduced. Now, most non-spouse beneficiaries must withdraw all funds from the account within 10 years. This means a much faster timeline for liquidating the account—and a much bigger tax bill in a shorter period.

A Quick Comparison

Under the old rules:

• A $500,000 IRA inherited at age 45 could generate roughly $1.6 million by age 85, assuming a 5.1% annual return and only taking the required distribution each year.
• Taxes were paid gradually, keeping the burden manageable.

Under the new rules:

• That same $500,000 must be withdrawn within 10 years, yielding about $632,000 in income.
• Taxes hit harder and faster, leaving beneficiaries with significantly less over time.

These are not representative of an actual client experience.  It is a hypothetical example for illustrative purposes.

Why This Matters

The accelerated withdrawal timeline creates a tax crunch. If your heirs are in their peak earning years, the added income from the IRA could push them into a higher tax bracket. This means a larger portion of the money you worked so hard to save ends up going to Uncle Sam.

What Can You Do?

Thankfully, there are ways to minimize the tax hit and ensure more of your money stays with your family. Here are some strategies:

1. Convert to a Roth IRA

• With a Roth IRA, contributions are made with after-tax dollars.
• Withdrawals, including for your heirs, are generally tax-free.
• Converting a traditional IRA to a Roth IRA might mean paying taxes now, but it could save your heirs a fortune later.
• This strategy is particularly useful if your heirs are in a higher tax bracket than you are.

2. Use Life Insurance

• Life insurance payouts are tax-free for beneficiaries.
• You can use funds from your IRA to pay the premiums, ensuring your heirs receive a tax-free inheritance.
• This can replace the value lost to taxes on traditional IRA withdrawals.

3. Optimize Contributions

• If you’re still saving for retirement, consider prioritizing Roth accounts over traditional IRAs or 401(k)s.
• Roth accounts allow your savings to grow tax-free, reducing the tax burden for your heirs.

4. Consider Beneficiary Planning

• Not all heirs have the same financial situation.
• For high-earning heirs, leaving Roth assets or cash might be better, while lower-earning heirs could benefit more from traditional accounts.
• Work with a financial planner to create a personalized strategy.

Special Considerations

Sometimes, traditional accounts still make sense. For example:

• If you’re in a high tax bracket and close to retirement, pre-tax contributions to a traditional IRA can reduce your current tax bill.
• Business owners and those with complex tax situations might benefit from specific deductions tied to traditional accounts.

The Role of Compounding

No matter which strategy you choose, the magic of compounding is key. By minimizing taxes and allowing your investments to grow longer, you can create a much larger inheritance for your loved ones.

Final Thoughts

Planning for your family’s future is about more than just saving—it’s about making the most of what you’ve saved. Traditional IRAs and 401(k)s may not be the best legacy assets due to their new tax challenges. But with careful planning, you can make smarter decisions to reduce taxes and maximize the impact of your hard-earned money.

If you’re ready to take the next step, talk to one of our financial planners. They can help you tailor a plan to fit your unique goals and ensure your loved ones are taken care of.