If You Don’t Need Your RMDs, Should You Reinvest Them in a Taxable Account for Your Kids?
If you have spent 40 years being told to put as much money as possible into an IRA or 401(k), this may sound backwards.
The taxable account may be the better account to leave your kids.
Not always. There are too many variables for a rule that simple. But if you are retired, taking required minimum distributions you don’t need, and still expect to leave money to your adult children, it is a question worth asking.
The reason comes down to how the two accounts are taxed after you die.
For example, say you bought $100,000 of investments in a taxable brokerage account years ago, and by the time you die, they are worth $400,000.
Under current tax law, inherited property generally receives a new cost basis equal to its fair market value at death. So your kids could inherit the $400,000 account with a basis of roughly $400,000. If they sold the investments shortly afterward for about the same amount, there could be little or no capital gain to tax.
That $300,000 of growth may disappear from the capital gains calculation.
Now put the same $400,000 inside a traditional IRA.
Your kids don’t get the same basis reset. Distributions from an inherited traditional IRA are generally taxable income to the beneficiary, although any basis from nondeductible contributions can change the taxable amount.
And the tax rules put a clock on the account.
For many adult children who inherit an IRA from a parent, the account has to be completely distributed by the end of the 10th year after the parent’s death. If the parent had already reached the required beginning date for RMDs, annual distributions generally have to continue during that 10 year period as well. If the parent died before the required beginning date, distributions generally can wait, as long as the account is emptied by the deadline.
Spouses and certain other beneficiaries have different rules.
A child who inherits a $400,000 taxable account may be able to sell the investments with very little immediate capital gains tax, meaning they may pay next to nothing in capital gains taxes.
A child who inherits a $400,000 traditional IRA may have $400,000 of future taxable income that has to come out within a relatively short period.
By the way, it’s not uncommon for adult children to inherit an IRA at exactly the wrong time.
They may be 50 or 55 years old, making the most money they have ever made, with a spouse who is also working. Now they have inherited IRA distributions stacked on top of their salaries.
It’s a nice problem to have, for sure. But it’s still a problem, and sometimes one that could have been reduced with a little foresight.
So, this raises a question for retirees who are already taking RMDs and don’t need the money.
What do you do with it?
You have to take the RMD. You have to pay whatever tax is due on the distribution. But you don’t have to spend what is left.
You could reinvest the after tax proceeds into a taxable brokerage account.
Over time, that starts moving money from an account that may eventually create taxable income for your kids into an account whose investments may receive a new basis when you die.
There is no tax magic happening here. You paid the income tax when the money came out of the IRA. The question is whether paying some of that tax during your lifetime makes sense compared with leaving the tax bill for your kids.
And that depends on a lot more than the words “step up in basis.”
Suppose you are in a high tax bracket today and your kids are likely to be in a much lower bracket when they inherit the money. Accelerating IRA withdrawals could be counterproductive.
Maybe you have large charitable goals. Traditional IRA money can be particularly useful for charitable giving because a qualified charity generally doesn’t have the same income tax problem an individual beneficiary does.
Maybe your spouse will inherit the IRA first. A surviving spouse has substantially more options than an adult child inheriting the same account.
Or maybe the better move is a Roth conversion. You pay tax now, but future qualified Roth distributions can be tax free. That creates a completely different comparison.
This is why I wouldn’t look at your IRA, taxable account, and estate plan as separate decisions.
If you have more money than you expect to spend, eventually you may be planning two retirements. Yours and the retirement your kids may partially fund with whatever you leave behind.
The account with the biggest balance on the day you die isn’t necessarily the account that leaves your kids with the most spendable money.
So, if you are taking RMDs you don’t need, I would ask a different question:
Which assets will your kids ultimately pay the least taxes on?
This article is for educational purposes. It is not personalized advice, a recommendation, or an offer. Decisions about IRA distributions, Roth conversions, taxes, and estate planning depend on your full plan and current law. Talk with a CFP or CPA before acting.
