For many families, leaving money to children is one of the most important goals in a financial plan.
But not all inherited dollars are created equal.
A $500,000 traditional IRA, a $500,000 Roth IRA, and a $500,000 taxable brokerage account may look identical on a net-worth statement. To the child who eventually inherits them, though, they can produce dramatically different tax outcomes.
That difference matters even more now that many adult children inherit retirement accounts during their own peak earning years. A 58-year-old executive, physician, small-business owner, or dual-income household may already be in a high tax bracket. Add a large inherited traditional IRA distribution to that income, and the tax bill can be much larger than Mom or Dad ever expected.
The goal is not to avoid paying taxes at all costs. It is to understand which assets are most efficient to spend, preserve, or leave behind.
The account statement does not tell the full story
It is easy to think of an inheritance as a single pool of money. In reality, each account type carries its own tax treatment.
Asset inherited | What the beneficiary generally receives | Main tax consideration |
Traditional IRA or 401(k) | Tax-deferred retirement assets | Withdrawals are generally taxed as ordinary income |
Roth IRA | Potentially tax-free retirement assets | Qualified withdrawals are generally tax-free, and the account may continue compounding tax-free during the distribution window |
Taxable brokerage account | Stocks, funds, bonds, or cash held outside a retirement account | Investments generally receive a step-up in cost basis at death |
Cash or bank accounts | Dollar-for-dollar cash | No embedded capital gain, but no additional tax advantage either |
This is why a parent’s estate plan should not stop at deciding who receives what percentage of the estate. The type of account can matter just as much as the amount.
The inherited IRA tax bill can arrive at the wrong time
The SECURE Act changed the way many inherited retirement accounts are handled.
Most adult children who inherit an IRA are required to fully distribute it within 10 years. If the original owner had already begun required minimum distributions, the beneficiary may also need to take annual distributions during the first nine years. Either way, the account generally needs to be empty by the end of year 10.
That can create a problem for families with substantial traditional IRA balances.
Imagine a child inheriting a $750,000 traditional IRA at age 55. They may be earning their highest salary, contributing to their own retirement plan, helping children through college, and beginning to think seriously about retirement.
The inherited IRA does not care that the timing is inconvenient.
Every dollar withdrawn from a traditional inherited IRA is generally added to taxable income. A large distribution may push the beneficiary into a higher marginal tax bracket. It may also affect deductions, tax credits, Medicare premiums later in life, and the taxes owed on other income.
Waiting until year 10 can be especially costly. The account may continue to grow, but the beneficiary could eventually face a forced distribution at the same time they are already in a high-income year.
The better approach is often to plan distributions deliberately. That could mean taking smaller withdrawals over several years, filling lower tax brackets when available, or coordinating distributions with lower-income periods such as retirement, a career transition, or a year with unusual deductions.
The point is not that every inherited IRA should be emptied immediately. The point is that “wait until year 10” is not a tax strategy by itself.
Roth IRAs can give heirs something more valuable
A Roth IRA can be one of the most attractive assets to leave to children.
Most non-spouse beneficiaries are still subject to the 10-year distribution rule for an inherited Roth IRA. But there is an important difference: assuming the Roth IRA has met its applicable five-year requirement, qualified distributions to the beneficiary are generally income-tax-free.
That gives the inherited Roth IRA a powerful advantage.
Instead of being forced to add withdrawals to an already high income, the beneficiary can allow the assets to remain invested and continue growing tax-free for much of the 10-year window. At the end of that period, the inherited Roth IRA and any subsequent gain can generally be distributed without a tax bill.
Consider two children who each inherit $500,000.
One inherits a traditional IRA and eventually must report the distribution as ordinary income. The other inherits a Roth IRA, lets the account compound for several years, and receives qualified distributions tax-free.
The account values might have started at the same amount, but the after-tax inheritance can look very different.
That does not mean a Roth conversion is automatically right for every retiree. Converting a large traditional IRA can create a meaningful tax bill today. But for families with the assets to pay conversion taxes outside the IRA, a well-timed conversion strategy may be a way to move some future tax liability away from children who could otherwise inherit the account in their peak earning years.
Taxable accounts can receive a reset
Taxable brokerage accounts, sometimes called non-qualified accounts, are often overlooked in estate planning because they do not come with the same headline tax benefits as retirement accounts.
But they have an important feature: a step-up in basis.
Suppose someone bought a stock or mutual fund for $100,000 and it is worth $400,000 when they die. If that asset passes to a child, the child’s cost basis is generally adjusted to the value at the date of death.
In this example, the child generally does not inherit the parent’s $300,000 unrealized capital gain.
If the child sells the investment shortly after inheriting it for approximately $400,000, there may be little or no capital gain to report. The investment can also be retained as part of the child’s portfolio, with future gains measured from the new stepped-up value.
That is very different from a traditional IRA.
A traditional IRA does not receive a step-up. The beneficiary inherits the obligation to pay ordinary income tax as funds are distributed. In other words, the account may have grown tax-deferred during the original owner’s lifetime, but the tax bill has not disappeared. It has simply moved to the next generation.
Which assets should be spent first?
There is no universal order that works for every household. Spending needs, charitable goals, tax brackets, health, longevity, and the size of the estate all matter.
Still, the general estate-planning logic is often worth considering:
- Traditional IRA assets can be less efficient to leave to children because those beneficiaries may be forced to recognize ordinary income over a relatively short period.
- Roth IRA assets can be highly efficient legacy assets because they may provide up to 10 additional years of tax-free compounding and qualified distributions can be received tax-free.
- Taxable brokerage assets can be attractive assets to pass on because of the potential step-up in basis.
- Highly appreciated taxable assets may be worth holding rather than selling simply to avoid a capital gain during the owner’s lifetime.
That does not mean retirees should drain every traditional IRA first or refuse to spend from taxable accounts. Asset location and withdrawal strategy should serve the family’s actual retirement plan, not a rule of thumb.
But when legacy goals matter, the tax character of each dollar matters too.
Bottom Line
Estate planning is often discussed in legal terms: wills, trusts, beneficiaries, powers of attorney, and account titles. Those are essential.
But for many families, the most meaningful planning question is simpler:
What will our children actually keep after taxes?
A family may have done an excellent job saving in traditional retirement accounts. Yet if those accounts are inherited by children in their peak earning years, a large share can eventually be claimed by the IRS through ordinary income taxes.
By contrast, a Roth IRA may provide a decade of additional tax-free growth. A taxable brokerage account may receive a step-up in basis. And a thoughtful distribution strategy during retirement may reduce the size of the future tax problem before it becomes the children’s problem.
The best inheritance plan is not just about leaving money behind.
It is about leaving the right assets behind, in the right places, with a plan for what happens after the account statement becomes someone else’s responsibility.
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.