Most investors have one overriding goal: to build a nest egg that will last as long as they do. But some who are lucky or talented focus on something else: passing assets to heirs.
It's not as simple as just leaving a list of accounts. Steps taken years before the inevitable can help minimize taxes and headaches for those who inherit.
"The biggest mistake when it comes to passing investments on to heirs is not knowing the rules (on what will happen) when you pass away," says Patrick Simasko, elder law attorney and wealth preservation specialist at Simasko Law in Mount Clemens, Michigan.
Many investors want assets passed to children and, if one should die, to that child's children, he says. But if accounts were not set up properly, the law may distribute the child's portion to the investor's other children instead.
"You hope your surviving children will follow your wishes," he says. "Keep hoping, as in many cases they won't. They will find a reason to cut out those grandchildren every time."
The major issues for investors to consider for their heirs include:
-- Family relationships.
-- Estate and gift taxes.
-- Roth conversions.
-- Record keeping.
Experts say that to make sure wishes are followed even young investors in good health should be careful to have an up-to-date will, living will and power of attorney, and to name the right beneficiaries on insurance policies, individual retirement accounts and other assets. Beneficiary designations are easy to overlook on accounts that have been around a long time and need updating.
"Many estate planning professionals focus solely on the most tax efficient way to distribute assets, losing sight of what is really much more important -- family harmony," says Greg Kushner, founder, chairman and CEO of Lido Advisors in Los Angeles.
He says investors often choose one child as executor to their estate without thinking how this will sit with the others, so it's a matter to be considered carefully and revisited as conditions change.
Estate and Gift Taxes
Most small investors don't have to worry about estate tax these days, since the first $11.4 million per individual, and $22.8 million for a married couple, is exempt. In addition, assets passed to heirs while the giver is still alive are exempt from tax if below $15,000 per year per recipient.
Still, the rules are tricky. You can exceed the $15,000 limit, for example, by paying college tuition for a child or grandchild. Also, Congress could trim those exemptions someday. So investors with big holdings and big hearts should get professional advice.
Life insurance, of course, can pass substantial sums to heirs, or just offset any taxes they might face on selling inherited assets.
"Very few instruments can outperform the payout ratios of life insurance death claims when it comes to passing assets to heirs, unless you want to take on substantial amounts of risk," says Nelson Lee, managing partner at Pacific Wealth Solutions, a California insurance firm.
Term policies are the least expensive but cover the insured for only a given number of years, so Lee recommends a permanent policy that will last for life.
Investors with traditional IRAs and 401(k)s can convert them into Roth versions that do not tax withdrawals. Conversion involves paying tax on holdings that have not been taxed before, such as investment gains and contributions on which deductions were claimed. The trade-off is paying tax to convert to avoid tax on withdrawal, so it's worth doing if the current tax rate is lower than the one expected later.
"In the simplest of terms, if the beneficiary's tax rates are higher, it would make sense for the current IRA owner to convert the IRA, pay the taxes now at current rates, and bequest the higher-income beneficiary a tax-free account," says John O'Rourke III, vice president at First American Bank in Coral Gables, Florida.
"If on the other hand, the beneficiary's income is less, fewer assets reside in the lower-taxed state, etc., then it may make more sense to leave the traditional IRA (or 401k) alone and have the beneficiary pay at their lower rate(s)" on withdrawals after inheriting, he says.
These insurance policies are typically used to provide the owner with lifetime income starting immediately or some years after the policy is purchased. Annuity holders willing to take a lower income can have it continue for the life of a spouse as well, and some annuities include death benefits paid to a spouse or other beneficiary.
"If the annuity has a death-benefit provision or very specific details within the agreement, the owner can designate one or several beneficiaries to inherit the remaining funds after death," O'Rourke says.
Since the annuity is customized for the policy holder, it's essential to know what the contract says.
Obviously, heirs will be happier, and perhaps wealthier, if they also inherit clear records.
"The IRS expects you to keep and maintain accurate records clearly stating your cost basis in the investments, O'Rourke says. "I recommend keeping hard copies as well and scanning for back-up" in a computer and on the cloud.
Most assets are "stepped-up" upon the owner's death -- the cost basis for heirs becomes the value on the deceased's death rather than the price originally paid. (Cost is subtracted from sales proceeds to determine capital gains tax after heirs sell inherited assets.) The step-up eliminates many potential headaches, but snags are still possible.
"We recommend that our clients complete an "Important Documents Locator" which outlines all assets, where they are held -- brokerage firm, safe deposit box, etc. -- and a list of important contacts," Kushner says. "Even things like passwords, airline and hotel rewards points and burial instructions should be provided."